Why use a balance sheet: 3 reason to start
Much is found online about how to read a balance sheet. What is not clear is why a small business owner should care. Why should a business owner take the time to learn how to read a balance sheet? There are many other pressing needs a business owner needs to attend to. And in fact, the balance sheet is the domain of the Accountant and senior lender, correct? Wrong.
Risks exist in referring to your Accountant and banker on your business’s balance sheet contents. First, a business owner has some familiarity with the income statement. A business owner likely monitors revenue and gross profit in the income statement. At a minimum, a business owner maintains a close eye on the net income at the end of the year and at tax time. Using the income statement without the balance sheet is similar to fighting with one hand tied behind your back.
Many business owners ask themselves, why use a balance sheet? The following are three reasons to use a balance sheet as a tool to organize and operate a business:
1. Anticipate
When you operate a vehicle, you first examine the fuel gauge; you wouldn’t leave on a trip without looking at the fuel gauge, would you? The balance sheet displays how full the fuel tank is, while the income statement and the statement of cash flows illustrate how much fuel the business is burning. Collectively, the balance sheet, the income statement, and the statement of cash flows allow anticipate how far the fuel in the fuel tank will take you. A balance sheet uncovers the ability to pay current expenses and future expenses in a business. Does the company have the cash and accounts receivables to cover payables or loan payments? Understanding what the business owes and what is owed to the business may prevent overextending with a next hire or purchase. In addition, understanding the information of accounts payables and accounts receivables may prompt timely collections calls. Monitoring accounts receivables monthly will enable the business to anticipate cash shortages months in advance. As a business owner, it is vital to know about a decline in cash balances while there is still time to properly take corrective action, not when a check is dishonored!
2. Monitor
Business owners watch specific metrics to ascertain operations remain on track. However, many times, business owners monitor the wrong metrics for the industry, or the information is insufficient to provide appropriate insight. To enable useful industry-specific metrics, a business owner must monitor the building blocks for the reports. For example, a business structure with annual recurring revenue is better informed if it tracks unearned income on its balance sheet. Unearned revenue, known as deferred revenue, helps a business with yearly memberships see trends in bookings from a different perspective. For example, if the deferred revenue trend is growing, the company is selling faster than the memberships are being consumed, otherwise known as recognized revenue. Conversely, if unearned revenue declines, the company will need to assess churn and new bookings. In addition, deferred income can help a business determine corporate priorities and the team members’ questions that need to be tended.
Each industry has its specific nuances; a well-designed balance sheet will take these nuances into account.
2. Communicate
The balance sheet is the universal means for conveying a firm’s financial position to current and prospective partners. For example, investors and banks need to assess the company’s balance sheet to entertain an investment or a loan. In addition, strategic customers or vendors use the balance sheet to ensure the firm has the financial wherewithal to support a long-term relationship. Access and readiness to the prior month’s balance sheet, and in conjunction with fluency in balance sheet concepts, will ensure clear communication with current and prospective partners’ needs.
The balance sheet will communicate the ability to manage the company’s profitable growth; it will answer if the business can afford a new hire, it will respond if a bank is comfortable expanding a line of credit, or is now the right time for the new capital expenditure.
