Too many business owners ignore their balance sheet. After all, as long as a company is making a profit, why bother with the balance sheet, right? Wrong! The answer to “Why bother?” is one four-letter word — CASH! If you think of profit as the heart of your business, think of cash as the blood. You must keep the blood pumping!
There are numerous business transactions that affect cash, but not the profit statement. For instance, principal payments on loans require cash. These same principal payments, however, don’t show up anywhere on an income statement. Here’s another example: What happens to your income statement when you go out and buy a big, shiny new truck? The answer is nothing, but, that purchase can sure have a big impact on your cash!
When an owner or controller picks up a company balance sheet, here’s what to look for:
Step 1) True Cash Position – It’s not enough to look at the cash balance on the month-end balance sheet. To know your company’s true cash position you must subtract out any short-term working capital loan amounts from cash.
For instance, two companies have financial statements that each show $500,000 in cash. One company has no working capital debt, while the other company has a line balance of $750,000. The first company has a true cash position of $500,000 while the second company has a cash deficit of $250,000! As you can see, there is a major difference in the true cash position of the two companies although they have exactly the same amount of cash!
Step 2) Critical Factor – There are three items on a balance sheet that together have a major impact on cash — accounts receivable, inventory and accounts payable. Ideally, we want any increase in either receivables or inventory to be financed by our suppliers. When there is a major increase in receivables and/or inventory without a corresponding increase in payables, we are guaranteed a drain on cash.
To determine the critical factor, we must compute the sum of the change in the three components from period to period. For instance, if we want to see what happened to our critical factor for October, we take the change in the three items from the balance sheet dated 9/30 to the one dated 10/31.
By computing the critical factor as the second step in balance sheet analysis, you will know right away if there has been a significant dollar increase in either receivables or inventory. An increase in the dollar balance, however, does not necessarily mean a problem. To detect a problem in receivables or inventory, you must look at the average days to collect receivables and the average days inventory supply on hand.
Step 3) Accounts Receivable and Inventory Supply Days – For receivables, divide the receivables on the balance sheet by an average day’s sales. To get average day’s sales, take sales for the month and divide by 30. Once you have computed the days collection time, compare your results to your selling terms. Over time, watch this number to be sure it doesn’t creep steadily upward.
For inventory, divide the inventory amount on the balance sheet by an average day’s cost of goods sold. This will let you determine your inventory supply level. You want to keep your inventory lean while still maximizing your sales volume and profit. Any increase in average supply hurts cash flow and should be targeted for reduction.
Step 4) Equity Percentage – On your balance sheet, look at your equity (equity equals assets minus liabilities) and divide that number by total assets. Bankers and creditors like the percentage to be at least 25% and in fact feel more warm and cozy when the percentage is up over 30%.
How do marketers get an equity position lower than 25% and in jeopardy? That’s simple — they borrow too heavily (more than 75%) when purchasing new fixed assets. Small equity percentages can also happen when a company’s receivables and inventory grow, causing total assets to increase, yet the company’s profit does not increase proportionately. Any owner that keeps receivables and inventory under tight management, and borrows no more than 75% on new projects, will be able to keep a good equity position.
That’s it. Just four steps to keep your finger on your company’s cash pulse.
