Your balance sheet (now more correctly called a statement of financial position) reveals a great deal about your business – the total value of your assets, how much you owe, and your level of solvency. Lenders, investors and potential buyers study these closely, but they should matter to you too, because it’s important to be solvent at all times: to have more assets than liabilities available to pay your debts. If you can’t pay bills when they fall due, your business may be technically insolvent. Two simple tests can quickly reveal your solvency.
The current ratio test
Divide your assets by your liabilities (both figures are on the balance sheet). For example, a business with assets of $435,000 and liabilities of $180,000 has a current ratio of 2.42 – $2.42 in assets for every $1 of debt. On the face of it that’s solvent, as the minimum most banks regard as acceptable is $2 for every $1 of debt. But your assets include stock. What’s it really worth? If you had to sell it all tomorrow, could you get the full amount shown?
The quick ratio test
Now a tougher test that leaves out your stock, to see whether you have enough ready cash to pay your bills if creditors demanded repayment tomorrow. If the business has $325,000 in stock, subtract it from the $435,000 in assets, leaving $110,000. The quick ratio is $110,000 divided by $180,000 = 0.61 – only 61 cents in ready cash for every dollar of debt, meaning it couldn’t immediately pay its debts. Aim for at least $1 in quick cash for every $1 of debt, a ratio of 1:1. You’ll sleep better, and so will your bank manager.
Strengthening your balance sheet
A positive step is to look closely at the quality of your inventory. If you had to sell all your stock in the next week or month, would you get the full amount shown? In many businesses the answer is no. If you have obsolete or slow-moving stock, talk to us about clearing it – holding a sale, bundling unwanted stock with popular items as a special offer, or choosing the most advantageous time of year to write it off. We can also show you how to measure your stock-turn rate: broadly, the faster you turn over stock, the more efficient your business.
Closing tips
Many people find a balance sheet harder to read than a profit and loss account. If that’s you, we can help you understand it and get more from the figures. And getting a balance sheet just once a year isn’t enough – with the right accounting software you can generate one whenever you need it.