Quick — what shape is your company in? You’d be surprised how many entrepreneurs have no idea, or think they know but are wrong.
Take Jack, for example. His business provides shoreline cleaning services to waterfront property owners. He carefully costs out every job based on labor and transportation costs, to make sure it will earn a profit. Yet, he’s deep in debt. And the money he borrowed to buy additional equipment, went instead to debt repayment.
If only Jack had done a complete balance sheet, he would have known that he was forgetting to factor in some long-term overhead costs.
The balance sheet gives you a snapshot of your current position, and an early warning sign of trouble to come unless you change something.
Assets to Liabilities Ratio
The formula: Current Liabilities ÷ Current Assets = Debt to Equity Ratio
This shows you the company’s solvency: its ability to pay its bills. Ideally, you should have more current assets (which you expect to be converted to cash within the year) than current liabilities (which you must pay within a year).
If the ratio is 1 (assets are the same amount as liabilities), you’re breaking even.
If it’s less, you’re bankrupt, even if you think you’re making a profit. Paper profits won’t give you the cash you need to keep the doors open. A negative ratio may be a particularly acute problem for businesses that are cyclical in nature and thus subject to widely fluctuating cash flow.
First, take immediate action, such as putting off some debt payments or stepping up the collection of receivables. Then you’ll need to plan a long-term strategy for adjusting the ratio. (Hint: borrowing more money is not the answer.)
Debt to Equity Ratio
The formula: Total Liabilities ÷ Total Equity = Debt to Equity Ratio
This compares the amounts of company financing that come from creditors (such as a bank) vs. investors (stockholders). A high debt to equity ratio might indicate financial instability or signal future problems in repaying debt.
Each industry as its own norms; some just tend to use more debt financing. In general, though, a business with a higher ratio would be considered a more risky investment. Plus, it’s often more expensive since you have to pay interest and debt servicing costs on the loan.
Asset Turnover Ratio
The formula: Net Sales ÷ Average Total Assets = Asset Turnover Ratio
(Net sales is found on the income statement; average total assets should be calculated from the beginning and ending balance sheets of the last 2 years)
This efficiency ratio measures how effectively your business generates sales from its assets. Again, some types of business inherently have better turnover than others; so a necessary step is to compare your ratio with what’s standard for your industry.
In general, though, a low ratio is a red flag to potential investors or lenders. For example, if your average total assets are $100,000 and net sales are $20,000, your ratio is .2 (20%). In other words, for every dollar in assets, you are only generating 20 cents in sales. A low asset turnover ratio often points to problems with management or production processes.
With these and other accounting ratios, the balance sheet can be used to take the “temperature” of your company’s health. That’s why it’s one of the essential bookkeeping reports you should get from your accountant.
Xendoo provides our clients with balance sheets and other financial statements that answer all the questions about their company’s financial health. Then they can focus on growing their core business with confidence that they’re making the right moves.