In our introduction to bookkeeping basics we’ve already examined what a balance sheet is. In this article we dig down a little to see what measures can be drawn from it. Often these are called Key Performance Indicators (KPIs), because they let you gain insight into the parts of your business finances that really matter. Monitoring KPIs puts financial decisions making at the heart of your business mindset.
Below we take a look at some of them, and look at how they directly impact the health of your business as well as its potential for growth.
1. Knowing how much is owed to you
Keeping track of who owes you cash and how much they owe you can be difficult, especially when you’re focused on grinding out sales or services to keep your business going. However, without following up on customers and their unpaid or partly paid invoices, your business can quickly run into financial difficulties.
In fact, according to a study conducted by Sage, 11% of all invoices issued by SMEs are paid late. This results in estimated late payments each year of CAD103bn in Canada alone, and an estimated CAD82bn in bad debts.
In the balance sheet how much you’re owed is listed under the Accounts Receivable heading, within the Assets section. This is because debt is considered a part of your business’ assets—and debt is often sold via factoring agents, who purchase the debt from businesses in return for taking a cut from the total amount.
Studying your balance sheet should provide a quick overview of how much you’re exposed to your debt. Regularly comparing this against your liabilities is a fundamental tenet of business.
Following this you can delve into your small business accounting software to identify who you need to reach out to so you can ensure you get the cash.
Without having visibility into this information, it’s like you’re delicately balancing your company’s cash flow with one hand while walking a tight rope, in the dark.
While insight into who owes you cash and how much certainly helps, you also need to know when to chase payments. Again, your accounting small business accounting software can help here and should include some kind of functionality to drill down into your accounts receivable to see due dates. Amounts overdue will be flagged by the small business accounting software, typically in red so that you don’t miss them!
Keeping your finger on the pulse of your company’s cash in-flow is much better than wondering when the next “ping” from your bank is going to hit your mobile phone.
2. Know how much you owe
They call it cash flow for a reason and, sadly, it’s not just about collecting money. Cash flows in, but it also needs to flow out. You need to ensure you pay your creditors, which is classed as one of the liabilities on the balance sheet.
Taking care of money owed is an important aspect of your company’s success because good payments can lead to better credit terms, provider longer for you to pay. On the flip side, if you leave a payment too late then you might find companies taking action against you, which adds to your expenses.
Inspecting your balance sheet’s Accounts Payable heading in the Liabilities section will provide an overview of how much you owe, and some balance sheets list this amount specifically under a Creditors heading.
Accounts Payable is especially important to consider when planning for the month or period ahead because you need to ensure that what you’re expecting to be paid is enough to cover what you’re expecting to pay out, or to pay for any expansion/purchasing plans you have.
Drilling down into your small business accounting software should let you see who you owe, and how long you have left on your terms to pay them.
Businesses often run into cash flow problems when they don’t have visibility into this information because they end up paying the wrong creditors at the wrong time. For example, you may think a payment is due for stock at the end of the month and so you quickly scrape together cash (you may even take out a loan) to get it paid.
However, this payment may only be due at the end of the following month, and so you could have delayed the payment and planned ahead to ensure you turn whatever stock you have left into cash to easily cover the payment.
Delaying payment until right until the end of the agreed terms isn’t a bad thing in business. Unlike in your personal finance dealings there’s no honour in paying early, and the businesses you work with won’t expect it either.
Insight into when you have to pay your creditors is priceless because it can also empower you to further bolster your cash flow by renegotiating terms if necessary.
3. Working capital ratio
The balance sheet displays fundamental data, and basic calculations can be carried using them to indicate the health of your business. Typically, these are ratios between two contrasting items, such as profit and loss.
One of the most useful is the working capital ratio, and working it out is really simple. In fact, your small business accounting software will almost certainly already do it for you, but working it out manually can be done as follows:
Current assets ÷ current liabilities
Obviously, you need to ensure your balance sheet is always up to date or this calculation also won’t be accurate.
Let’s stay your total assets according the balance sheet are worth $10,000, while your liabilities are worth $8,000. You can probably see instantly that this is a good position to be in—that it indicates your business has liquidity.
A result better than 1 is what we’re looking for, and here it’s 1.25. Hoorah!
A negative result such as 0.85 indicates a potentially serious issue because it’s unlikely the business is going to be able to meet its obligations. Cash flow will need to be boosted somehow, possibly by taking out of a loan, or quickly liquidating stock. Or you might chase up some of those debts that are outstanding—although, as mentioned above, this should be the default working practice for your business and if it isn’t then the business can’t be considered well-run.
A negative working capital ratio isn’t always bad. Some businesses built around holding large inventories might find themselves with perpetually negative working capital ratios, and this consideration has to be taken into account in their financial planning—and also indicates that working capital ratio is useful but shouldn’t be considered a perfect measure. However, there’s little doubt that if you approach a bank for a loan with a working capital ratio of less than one then the bank manager is likely to frown—and it will take quite a lot of negotiation to get her on side.