Saturday, 5 February 2011

Small Business Advice Part Four - The Vital Importance Of Your Balance Sheet

Now that's a title to put readers off isn't it? And it's for precisely that reason that so many small businesses fail because, rather than being a boring and necessary evil prepared to keep the tax man at bay and the bank manager happy, a balance sheet is actually a vital business tool that provides the entrepreneur with all the information necessary to carry out regular health checks on his business.

When I was a bank manager a majority of my customers knew absolutely nothing about their balance sheets. For them it was a meaningless jumble of words and figures that their accountant charged them an extortionate fee for once a year and delivered to them about 18 months after the financial year had ended. As such, it was indeed both meaningless and worthless. What's the use of a set of figures that tells you how the business was doing 18 months ago? Now that computer accountancy packages are cheaply and readily available to all, there is nothing to stop business owners from preparing a balance sheet every month in order to keep fully abreast of how things are going. If your doctor offered you a free health check every month you'd jump at the chance. So why not do it for your business?

So what is a balance sheet? Put most simply it is a chart that documents two aspects of your company. These are what you have (your assets) and what you owe (your liabilities). As these two categories rarely equal each other, there is a third balancing item which represents the difference between the two and is your own stake or investment in the business plus any profit or minus any loss that you have made since inception. Hopefully you will see that third item grow as you check your balance sheet every month. It never ceased to amaze me how many of my customers had no idea whatsoever how much profit they were making from week to week or month to month but this simple chart would have placed the figures at their fingertips.

The two major categories on the balance sheet are each split into two. These break down the assets into what are known as fixed assets i.e. things like buildings, desks, cars and machines which, though used daily, don't generate ready cash and current assets which are, for example, cash, money in the bank, sums due to you in the near future and stock. Liabilities are split in a similar way with current and long term liabilities. Your current liabilities are those which will fall due within the next 12 months and may include a bank overdraft, sums outstanding owing to creditors, your next 12 months' mortgage and hire purchase repayments and sums owing for wages and tax. Your long term liabilities are loans, HP and mortgage repayments due in future years.

When you draw up your balance sheet you start with your fixed assets followed by your current assets and liabilities and finally your long term liabilities and your net investment. Here is a basic example for a pub.

Fixed Assets a)

Pub Building, Catering Equipt, Vehicle,Tables Chairs        £800,000

Current Assets b)
Drinks                          £ 30,000
Cash                            £  5,000
Food                            £  3,000
Total                            £ 38,000

Current Liabilities c)
Wholesaler                  £  40,000
Bank O/D                    £  25,000
HP&Mortgage             £  32,000
Tax                             £  13,000
Total                           £110,000 

Net Current Assets  d) (=b-c)                                              -£72,000

Long Term Liabilities e)

Mortgage                                                                           -£200,000

Total or balancing figure f)                                                  £528,000

Many people would look at this simple balance sheet and say that it was a good and strong one. Certainly the investor has over £500,000 in the business but can you spot the glaring problem facing the proprietor? 

From my experience so many business owners would fail to realise that with their current or immediate liabilities far exceeding their cash and current assets they were heading for difficulties in paying their bills. A negative figure in Net Current Assets (d) is usually a precursor for stormy waters ahead. If the owner of this pub had this balance sheet in front of him at the end of month one instead of some 12 months later he would have been totally aware that his business was facing a cash problem long before the bank started bouncing his cheques and the wholesaler stopped his credit. With such a large investment in the business, it would not be too difficult to sort things out. Assuming that the balancing figure f) was growing and the business was profitable, he would be able to take some long term finance to make things stronger. If f) was on the decline he would know that things were grim and be able to try and do something about it quickly to reduce losses. Assuming the business was profitable and he took out finance his balance sheet might then look like this. 
  
Fixed Assets a)

Pub Building, Catering Equipt, Vehicle,Tables Chairs        £800,000

Current Assets b)
Drinks                          £  30,000
Cash and bank            £150,000
Food                            £    3,000
Total                            £183,000

Current Liabilities c)
Wholesaler                  £  40,000
Bank O/D                    £            0
HP&Mortgage             £   50,000
Tax                             £   13,000
Total                           £ 103,000 

Net Current Assets d) (b-c)                                                 +£80,000

Long Term Liabilities e)

Mortgage                                                                           -£352,000

Total or balancing figure f)                                                  £528,000

As you can see, the investment or balancing figure remains exactly the same but now the publican has more than ample cash available to meet his bills having increased the mortgage on the property and he is in a far better position and may for example be able to use his cash to negotiate better deals with suppliers. 

So the two vital things to look at on your monthly balance sheet are d) your net current assets  - you want to see this figure healthily positive so that you know that you can meet your immediate bills- and f) your balancing figure - you want to see this increasing to show that the business is profitable. If it is not you can investigate why and do something about it rather than wait for things to collapse.

I know that your accountant will provide you with plenty more than just a balance sheet in your annual set of accounts and I will cover the other sections in a future blog but so many owners of small businesses fail to grasp the importance of this vital tool as a quick health check and I hope that this simplification might clarify for you what many see as the accountant's black art.