Balance Sheet

Ask any accountant and they’ll spout off the balance sheet equation (Assets = Liabilities + Owner’s Equity).  Ask most everyone else, and they’ll either look at you blankly or have a hard time remembering what goes where in that equation.  It’s simple, really, if you just picture it.

The balance sheet is nothing more than a pie graph where half is always “assets” and the remaining half is divided between “liabilities” and “equity”.  The proportion of equity to liabilities will change, but the total of the two must be equal to the dollar value of your assets.

Now you know how to visualize the balance sheet.  If you can hang on for a few more minutes of reading, I’ll tell you what it means to your business.  First let’s define the terms:

Assets will be divided between current and long-term assets on your balance sheet.  These are either cash or items you own that have cash value.  Examples include: accounts receivable, investment accounts, inventory, equipment, etc.  You’ll also find things like “prepaids” in your assets.  Prepaids are simply expenses you have paid in advance, so they don’t belong on your income statement yet (theoretically you could get them refunded if you don’t actually use them…hence cash value).

Liabilities are things you owe.  Like assets, liabilities are divided into current and long term liabilities.  The most common liability accounts are: accounts payable, credit card debt, loans, lines of credit, etc.  Similar to prepaids, you’ll also find deferred taxes, deferred wages, accrued payroll, etc.  Customer deposits are also liabilities.  Revenue is recognized when it is earned, not when the customer pays you.  So, if the customer pays in advance, you record it as a liability until you have actually earned the revenue.

Equity is essentially what your business is worth.  Equity is reduced by dividends and distributions and increased by your net profit, capital investments, etc. 

Now that I’ve defined what’s on the balance sheet, let’s review what that means to your business.  Essentially, the balance sheet holds the keys to how well your business has functioned throughout its lifespan.  The income statement covers a period of time, while the balance sheet is an accrual of your business history.  Bankers are more concerned with how your balance sheet looks because it shows how well you’re running your business.

Don’t get me wrong, the income statement is important too.  The balance sheet and income statement together tell the story of your business.  Too often, I see owners concerned only about the profit and loss and there are many problems with that approach.

If you ignore that balance sheet and work under the assumption it is correct, you are setting your business up for failure.  The accuracy of the balance sheet is directly tied to the accuracy of your income statement.  The asset and liability accounts on the balance sheet hold income statement account items until the period they impact the income statement.  If you don’t move things to/from your balance sheet from/to your income statement in a timely manner, then you’re managing an incorrect income statement too.

Once you have an accurate balance sheet and income statement, the next step is to set up a dashboard and monitor your financial ratios (things like debt to equity, current ratio, receivables turnover, etc).  Ideally, you’ll determine the right ratios for your business in your industry and start utilizing all of this data to make decisions. 

Personally, I like to set up visual dashboards for the income statement, ratios, and other trend data.  The whole idea here is to become proactive with your financial data and keep (or make) your business healthy.  I find the easiest way to understand what is happening in a business is to make it visual.

~Kelly Totten, Top CrackerJack

I really don’t want to be a banker and I’m guessing you don’t either. The harsh reality is that any business with accounts receivable is acting as a banker.

With the current economy and banking situation, it’s important to realize that you are a banker…and you should act like one. In times when banks are failing and loan sources are drying up, your clients will be leaning on you more heavily to act as their banker. It’s critical to be careful when lending your money to your clients.

Fortunately, you can take steps to discourage the use of your cash by your clients. You need to put together a credit policy that is fair to your clients and consistent with your industry, but has enough teeth in it to protect your business. If you have employees administering the policy, you’ll want to make sure that the policy is clear and you have an escalation path for potential exceptions to the policy.

Some things you should be thinking about when you develop your credit policy include:

Who will you issue credit to? Does the company have to be a certain size? Maintain a certain D&B score? What gate will you put in place to lower your risk?

How much credit will you issue? When do you shut off the credit line? How much are you able to risk?

What are your payment terms? You’re giving a free loan to your clients. How long will you make that free money available?

What happens when they don’t pay within terms? Will you assess finance charges? (If you have to borrow money to cover the cash shortfall in your business, your client should have to cover that cost.) Will you send them to collections?

What are the alternatives for those who don’t qualify for the credit line they need? If you have a good credit policy in place, you will have customers who don’t meet the criteria for using your money. You should have some policies in place to help those customers. Some of the options here might include:

• Collecting a deposit – all or a portion prepaid
• Provide a very small credit limit, so the customer will have to pay any old invoices before accessing the line
• Accept a credit card and preauthorize the amount of the purchase

Of course, you’ll also want to consider your current client base and past payment experience. You’ll want to make sure that your current good paying clients do not suffer from your new policy. You should also take a look at your customer agreements and update them, as needed, to reflect your new terms.

Lending money is expensive and risky, but you can limit the risk. Set a credit policy that works for your business. Once you have a policy established, review it regularly to make sure it continues to work with your ever changing business, client base, and the economy.

For more information on writing credit policies, see Michelle Dunn’s Ultimate Credit and Collections Handbook.