As a business owner, it’s vital to understand what goes on in your balance sheet every month to determine your company’s financial health. Although having an accountant does help, it’s equally – if not more essential – for the business owner to understand the balance sheet as well. If you don’t, you might make financial decisions blindly and risk losing more capital than you earn.
This article explores how you can use five determining factors to get insight into your business’s financial health.
What is a balance sheet?
A balance sheet is a statement outlining your business’s assets, liabilities, and profits at a specific time and outlines what your company owns and what it owes. A typical balance sheet includes current assets, fixed assets, intangible assets, short-term liabilities, and long-term liabilities.
What are balance sheet ratios?
Balance sheet ratios determine the relationship between your business’s liquidity, solvency, and profitability. In other words, it evaluates your company’s financial performance based on its ability to turn assets into cash quickly (liquidity), pay off debts (solvency), and make a profit.
Why is it important to have these ratios? Because they provide deeper insight into your business’s financial standing, you can make short- and long-term financial decisions.
The top 5 balance sheet ratios for managing cash flow
A current ratio measures your company’s ability to pay short-term obligations by comparing your current assets with your existing debt.
Although the minimum current ratio is 1:1, you want to aim higher if you want more current assets than liabilities. A healthy current ratio would be between 1:5 and 2:0 because you have twice as many assets as liabilities.
How to calculate a current ratio:
Current ratio = Current assets/Current liabilities
Working capital ratio
This ratio is similar to the current ratio but outlines the available capital to cover existing debt and monthly overheads. In other words, the working capital ratio is the amount after liability payments.
It works hand-in-hand with your current ratio, which means that if the current ratio is negative, the working capital ratio is also negative.
How to calculate a working capital ratio:
Working capital ratio = Current assets – Current liabilities
Accounts receivable turnover in days
Accounts receivable turnover, or debtor’s turnover ratio, measures how effective your company is at extending its credit and collecting debts.
For example, if your company has a 30-day payment policy, your client has 30 days to pay you for the products or services you’ve already delivered. How effective you are at collecting that payment determines your accounts receivable turnover.
It’s crucial to manage your debtors well because only invoicing after you’ve done the work could mean waiting between one to three months to receive funds you’ve already worked for.
How to calculate accounts receivable turnover in days:
Step 1: Annual sales/Accounts receivable = Average payment per year
Step 2: 365 days in a year/Average payment per year = Average days outstanding
The average days outstanding are the number of days it takes to collect debt.
You would use a solvency ratio to determine if your business has enough capital to pay off long-term debts while still meeting short-term obligations. If you have a healthy solvency ratio, there is enough capital to cover long-term commitments and operate daily.
A solvency ratio of 20% or higher is considered healthy.
How to calculate a solvency ratio:
Solvency ratio = (Total net income + Depreciation)/Total liabilities
A breakeven point is where your monthly income and costs meet before making a profit.
To do the calculation, I would suggest having at least 12 months of profit and loss accounts to clearly understand your monthly overheads, including monthly debt repayments and owner’s drawings.
Remember to add in a bit extra to ensure you have more capital to work with. Overcalculating your breakeven point gives you more leeway, ensuring you have more than enough to cover your fixed costs.
How to calculate the breakeven point:
If you don’t work with stock, you can add all your fixed costs, add a bit extra, and work with the total as your breakeven point.
For retailers or businesses working with stock, you first need to determine your gross profit percentage before calculating your breakeven point.
Breakeven point = Total fixed costs/Gross profit percentage