Most entrepreneurs are not accountants.
That statement is as obvious as it is revealing. Despite not having the letters ‘CA’ or ‘CPA’ on their business cards, however, entrepreneurs are still expected to understand the finer details of financial management and balance sheet analysis. It’s an unfair expectation for any business owner who, most of the time, is focused on starting, managing and growing their businesses. That’s why they hire CFOs, in-house accounting teams or firms such as ours to help.
Without fail, though, every entrepreneur will at some point be forced to make often transformative financial decisions for their business based on a relatively limited understanding of accounting and finance. Many focus on important metrics such as gross revenue, EBITDA and profit to assess the financial health of their organization—and that’s a good starting point. But a more rounded understanding of a company’s financial fortunes requires a nuanced and detailed approach.
With that in mind, here are the five simple (yet often overlooked) balance sheet metrics you should understand, study and strive to optimize en route to growing your business:
Current ratio—This metric is used to compare a company’s current assets (which are the assets that can be turned into cash within 12 months) with its current liabilities (debt obligations due within 12 months). A ratio greater than one-to-one means that your assets exceed your liabilities, which is a good thing. A ratio of less than one-to-one, on the other hand, is a signal that your liabilities are greater than your assets. This may indicate that the organization is headed for financial difficulty. Current ratio, then, is an important measure of a company’s liquidity, and offers strong indications of whether it can meet debt obligations over the next 12 months. In an ideal scenario, companies would maintain current ratios of two-to-one (or better).
Working capital—This is a measure of current assets subtracted from current liabilities and highlights the funds available for the company to use in its day-to-day operations. Positive working capital is the goal because it’s an indication of strong financial capacity, while negative working capital means that you’ll likely need to fund business operations some other way—such as external financing or a personal loan. Lenders, bonding companies and investors will always assess your company’s working capital to determine its financial health and stability before offering their financial support.
Average collection period—This is a measure of the day’s sales in accounts receivable, or the amount of time it takes for your business to collect on accounts receivables from customers (thereby converting receivables into cash). Most businesses allow their customers to purchase goods or services on credit, but one of the key challenges that emerges is the protracted waiting period in between product or service delivery (and subsequent incursion of expenses) and receipt of payment. If your business provides credit terms of 30 days and your average collection period is 45 days, for example, this may indicate poor collections management (assuming that your credit terms are comparable to industry standards). Put simply, effective management of accounts receivables can lead to an improved average collection period. But remember: trying to enforce overly strict collection terms may alienate customers and limit sales. Optimizing your average collection period, therefore, requires a delicate balance.
Inventory turnover ratio—This is a very important metric because a significant amount of money can be tied up in inventory throughout the year, impeding cash flow and, in a worst-case scenario, sending many companies into receivership. A higher ratio is a strong indication of efficient inventory management, while a lower ratio may indicate obsolete, slow-moving inventory or a decline in demand. If the ratio deteriorates over several years, this is a strong indication that the company is holding worthless inventory.
Debt to equity ratio—This indicates the proportion of your company’s assets that are financed using debt. Not surprisingly, lenders and investors prefer low debt-to-equity ratios. A high ratio means that the company has been aggressive in financing its growth with debt instead of using its own resources. This is a glaring red flag for lenders and can severely hamper your future ability to finance growth through debt.
The important point to remember is that by analyzing these more abstruse balance sheet metrics, you not only have the opportunity to underscore fundamental business challenges, but also highlight opportunities for operational improvements. The potential benefit: bolstered bottom-line performance and the kind of game-changing growth that tops every entrepreneur’s strategic to-do list.
Adriano Romeo, Manager