A savvy investor or banker can glance at a balance sheet and quickly tell how well the business is doing. Numbers don’t lie. That’s why you need to have your balance sheet in good shape if you want to take out a business loan or attract investors. This article will walk you through how to construct a fortress balance sheet — one that stands strong against sudden financial crises. A strong balance sheet can make your business an attractive investment for growth and secure your future.
What makes a strong balance sheet?
A balance sheet provides a snapshot of your business’s total assets, debts and shareholder equity at a moment in time. It plays a crucial role in your ability to secure funding through a loan or investor. These are the main attributes of a strong balance sheet:
- More assets than liabilities. A cornerstone of a strong balance sheet is having more assets than liabilities. To run a business successfully, you need more money coming in than going out.
- Positive net assets. Net assets are the value of your assets after you pay your obligations. If you have plenty of assets after everything is paid off, your balance sheet is in a strong position. Businesses with positive net assets tend to do better in economic downturns than businesses with low net-asset positions. Net assets are calculated using the following formula: (total fixed assets + total current assets) — (total current liabilities + total long-term liabilities) = net assets.
- Strong assets. Assets alone won’t make your balance sheet healthy. Your assets must be active and valuable to count as positive contributions. Even if your inventory is valuable on paper, it’s not worth that much if you aren’t moving it. A strong balance sheet often has assets that provide value now rather than potential value later.
- Healthy receivables. You can have all the sales in the world, but if you don’t set up an accounts receivable process, your business can still struggle to get paid. Debtors who are slow to pay their bills can do real harm to a business. Healthy receivables reflect positively on your balance sheet.
FYI
Assets are what your business owns, such as property and equipment. Liabilities are what your business owes.
3 ways to analyze a balance sheet
Before you analyze your balance sheet, you need to learn a few key accounting ratios. These include the current ratio, the debt-to-equity ratio and the working capital ratio.
1. Current ratio.
Your business’s current ratio, calculated by dividing current assets by current liabilities, shows how much cash you have to run operations. Strive for a current ratio of 1.5 or higher.
2. Debt-to-equity ratio.
This ratio measures the amount of shareholder equity available to cover the business’s debts. The lower the ratio, the better a company is positioned to weather an economic downturn. Your debt-to-equity ratio is calculated by dividing total liabilities by total shareholder equity. The statement of shareholder equity, also known as owners’ equity, is the amount of money the business owner would receive if the business assets were liquidated and all the debts were paid off. Keep this ratio as low as possible for a strong balance sheet.
3. Working capital ratio.
This is calculated by dividing current assets by current liabilities. Most small businesses want a positive working capital ratio. Negative working capital means you don’t have enough cash to bankroll operations and could signal that you need to cut operational costs or unload assets.
Try calculating these ratios by hand at least once a month to keep them fresh in your mind.
4 ways to strengthen your balance sheet
Thinking about balance sheets isn’t the most exciting part of being a small business owner. However, if you want to position your business for growth or increase cash flow, building a fortress balance sheet should be a serious goal.
“A lot of small businesses just look at cash in and cash out,” Ben Richmond, country manager at Xero, told us. “The balance sheet is important because it gives you the full preview of your business.”
Every business is different, so there is no one-size-fits-all solution for strengthening your finances. Consider using some or all of these strategies to improve your cash flow statement and balance sheet.
1. Boost your debt-to-equity ratio.
It’s common sense that a business is generally better off with less debt and more cash on the balance sheet.
“If you get to a really low debt-to-equity ratio, you can use it to raise capital,” Richmond said.
To improve that part of your business’s assets, you need to bring in more sales that you can use to pay down debt. You may also have to unload assets, such as office equipment or real estate property. Boosting your debt-to-equity ratio will strengthen your balance sheet, improve cash flow and put you in a position to pursue growth.
2. Reduce the money going out.
A cash-flow deficit will quickly spell a small business’s demise, which is why reducing the money going out is an effective way to improve your balance sheet and bottom line. To optimize cash flow, Richmond advised mapping out different scenarios for the cash going out of the business, including the worst-case, best-case and likely scenarios. If your likely scenario looks a lot like the worst-case scenario, find ways to drastically cut business costs, Richmond said.
Did You Know?
Negative cash flow occurs when there is more cash flowing out of a business than coming in.
3. Build up a cash reserve.
In addition to managing the cash going in and out, monitoring the amount of cash held in your business savings account is crucial, said Val Steed, director of accountants at Zoho. You can use that pot of money for emergencies or to take advantage of an unexpected opportunity. Without cash in reserve, you might need to scramble to secure financing quickly.
“My general rule of thumb is, until you build up your hold or protective balance, one-third goes back into operations, one-third is invested back into the business to improve growth, and one-third is the hold,” Steed said.
4. Manage accounts receivable.
Getting paid is a big challenge for all small business owners. The longer bills go unpaid, the more pressure it puts on cash flow. Steed said to improve the balance sheet and cash flow, focus on managing receivables. That doesn’t mean sending out a bill reminder email and leaving it at that. Nor does it mean asking your salesperson to try collecting the amount owed. Rather, it requires you to put someone in charge of collecting overdue bills using persistence, patience and politeness.
“Never put a salesperson back on a bad account,” Steed said. “The salesperson stays in the good-guy role at all times.”
Simplify your business’s accounting
You should strongly consider using top small business accounting software to fine-tune your business’s finances. Accounting programs can generate balance sheets and cash flow statements automatically, as opposed to creating them by hand. Software also reduces human error and eliminates inefficient manual data entry.
The best accounting software is easy to use and able to integrate with your bank and other business apps. If you implement small business accounting software, you can significantly simplify your finances and put yourself on the path to building a solid balance sheet.
Mike Berner contributed to this article. Some source interviews were conducted for a previous version of the article.
Staff Writer
Donna Fuscaldo is a senior finance writer at business.com and has more than two decades of experience writing about business borrowing, funding, and investing for publications including the Wall Street Journal, Dow Jones Newswires, Bankrate, Investopedia, Motley Fool, and Foxbusiness.com. Most recently she was a senior contributor at Forbes covering the intersection of money and technology before joining business.com. Donna has carved out a name for herself in the finance and small business markets, writing hundreds of business articles offering advice, insightful analysis, and groundbreaking coverage. Her areas of focus at business.com include business loans, accounting, and retirement benefits.
