Your business’s balance sheet, which is also called a ‘statement of financial position, is the primary source of information about your business’s financial health. It tracks all your business’s assets and debts, thus giving a real-time value for your ‘net worth’. It also gives insight into the health of your business’s cash flow and the amount of working capital you have access to.
Having a strong balance sheet is important for your business no matter how small or big you are and regardless of the industry you operate in. Read on to find out why and learn how to assess the strength of your business’s balance sheet.
Why is a healthy balance sheet important for Cash Flow?
Your balance sheet provides a snapshot of everything your business owns as well as all the money it owes, accurate to the date specified on the balance sheet (this is usually the end of the financial year). When compared to previous balance sheets, your current balance sheet gives an indication of your business’s ability to collect and repay debts over time.
As a result, your balance sheet is a vital tool that current and potential investors and lenders will use to help them decide whether to lend resources to you. It’s also a valuable tool that you can use to detect warning signs of financial strife so that you can take action to overcome any challenges before they become serious problems.
Before you can use your balance sheet for this purpose, however, you need to know how to read it.
How to analyse your balance sheet?
Rather than using the figures directly recorded on your balance sheet to detect warning signs, you can get a better understanding of your business’s liquidity and ability to generate cash flow if you calculate a variety of ratios from the values on your balance sheet. The most useful ratios you can use for this purpose include the: current ratio, debt ratio, debt to equity ratio and days sales outstanding ratio.
The current ratio provides a measure of your business’s ability to pay short-term and long-term debts. It can be calculated using the following equation:
Current ratio = current assets / current liabilities
The larger your business’s current ratio is, the better.
The debt ratio gives a measure of your business’s leverage. It can be calculated using this equation:
Debt ratio = total liabilities / total assets
The lower your business’s debt ratio is, the better.
Debt to equity ratio
If you’re listed on a share market, you can use the debt to equity ratio to determine how much debt you’re using to finance your business’s assets relative to the value of your shareholders’ equity. This ratio can be calculated using the following formula:
Debt to equity ratio = total liabilities / shareholders’ equity
A lower debt to equity ratio indicates that your liabilities are well supported by shareholder investment.
Days sales outstanding ratio (DSO)
The DSO provides a measure of the average number of days it takes for you to collect payment after you have made a sale. Reducing this value is a key way to improve working capital and cash flow. DSO can be calculated via this formula:
DSO = accounts receivable / (annual sales / 365 days)
The lower your DSO, the faster you gain access to cash tied up in your accounts receivable ledger.
Want to improve the health of your balance sheet?
Our next blog post will detail four top tips for improving the health of your balance sheet and your cash flow so don’t miss it!