Success in any endeavor requires discipline. If you want to have six-pack abs and biceps like Chris Hemsworth, you eat your Wheaties and go to the gym. If you want to have healthy financial assets, you develop a strong balance sheet. Here’s how:
Understand Balance Sheet Vs. Income Statement
The balance sheet and the income statement work together hand-in-hand, linked by the equity section. Whatever income you generate is carried over to the balance sheet and reflected in equity. The difference is that the income statement shows revenue and expenses that equate to profit and loss of the business over time, while the balance sheet shows the overall financial position of the business in terms of assets and liabilities.
Get to Know Your Balance Sheet – If you have never done much with your balance sheet, spend some quality time getting to know what it includes and how it functions. A few key ratios that will provide insight into the health of your balance sheet are:
- Working Capital – Calculate working capital by subtracting current liabilities from current assets. This number shows you how much you have on hand to pay bills and manage day-to-day expenses of the business.
- Debt to Equity Ratio – Use this ratio to determine whether you have an appropriate amount of debt: not too much and not too little. A high debt-to-equity ratio is considered risky and may indicate that you are relying too heavily on debt to grow your business.
- Fixed-Charge Coverage Ratio – This ratio measures EBITDA (minus capital expenses and taxes) against fixed charges such as interest and lease payments. A higher number corresponds with less financial risk. If this ratio is too low, you may not have enough capital to meet regular financial obligations.
Zoom In On Specifics – As you saw in the example, a balance sheet is comprised of three categories of data:
- Assets – Assets include receivables, cash, inventory, investments, and other things that hold economic value. Having healthy assets means that your receivables are current, you have the right amount of cash (and a 13-week cash flow strategy to stay on track), your inventory is sustainable and meeting demand, and you have sufficient working capital.
- Liabilities – Liabilities include any debt associated with the business. This may include loans, accounts payable, mortgages, and expenses.
- Equity – When you subtract liabilities from assets, you get equity. This number shows the value inherent in the business for the owner and shareholders.
- Don’t Ignore It!– Many founders are intimidated by their balance sheet, so they don’t pay much attention to it. But that can land you in serious financial trouble if you have insufficient working capital to handle unexpected changes. If you feel intimidated by the idea of managing your balance sheet, reach out for help. Whatever you do, don’t ignore it!
What Does It All Mean?
Having a strong balance sheet means that you have ample cash, healthy assets, and an appropriate amount of debt. If all of these things are true, then you will have the resources you need to remain financially stable in any economy and to take advantage of opportunities that arise.
If you’re not there yet, we can help! At CFO Alliance, we work with founders every day to build strong financial systems and processes that position companies for financial success. Contact us to see how we can help you build financial confidence and grow!
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The article discusses the importance of maintaining a strong balance sheet for financial success, much like achieving physical fitness requires discipline and dedication. Let's break down the key concepts used in the article:
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Balance Sheet vs. Income Statement:
- The balance sheet and the income statement are two fundamental financial statements. They are interconnected through the equity section.
- The income statement presents revenue and expenses over a period, resulting in profit or loss.
- The balance sheet reflects the financial position of a business at a specific point in time, showing assets, liabilities, and equity.
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Working Capital:
- Working capital is a key ratio calculated by subtracting current liabilities from current assets.
- It indicates how much liquid capital a business has available to cover its short-term obligations and daily expenses.
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Debt to Equity Ratio:
- The debt to equity ratio is used to assess the proportion of debt and equity in a company's capital structure.
- It helps determine if a business has an appropriate balance of debt and equity. High ratios may indicate excessive reliance on debt, which can be risky.
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Fixed-Charge Coverage Ratio:
- This ratio measures a company's ability to cover fixed charges (e.g., interest and lease payments) with its earnings before interest, taxes, depreciation, and amortization (EBITDA).
- A higher ratio implies lower financial risk, while a lower ratio may indicate difficulty meeting financial obligations.
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Assets, Liabilities, and Equity:
- Assets encompass various items with economic value, such as receivables, cash, inventory, and investments.
- Liabilities consist of any debts owed by the business, including loans, accounts payable, and mortgages.
- Equity is the residual interest in the assets of the company after deducting liabilities. It represents the value for the owner and shareholders.
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Importance of Balance Sheet:
- The article emphasizes that many business founders neglect their balance sheets due to intimidation, which can lead to financial issues.
- A strong balance sheet with healthy assets, manageable debt, and sufficient working capital ensures financial stability in varying economic conditions.
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Financial Success:
- Having a strong balance sheet means having ample cash, healthy assets, and an appropriate level of debt.
- This financial strength allows a business to remain stable in any economic climate and seize opportunities that may arise.
The article promotes seeking professional assistance, like the services provided by CFO Alliance, to help founders manage their balance sheets effectively and build financial confidence for business growth.
