If you own a business or want to own a business, you absolutely need to understand your financial health. This column will focus on the balance sheet.
I will start off with a simple concept – Net worth. The technical accounting definition of net worth is Assets minus Liabilities. It has far greater meaning, however, if it is negative, “do not pass go, do not collect $200.00”. Your business is insolvent. You will not be able to meet your obligations (liabilities) without outside assistance. Borrowing from a lender does not cure the insolvency, as the cash you get is offset by this new liability.
I like to refer to net worth as the ability to withstand unanticipated losses. It can be real P&L losses, or it can be unexpected A/R or inventory write-offs, which will eventually flow to the P&L. This is the financial buffer to survive the storm.
Sadly, too many businesses in our industry began as “undercapitalized”. There was not enough net worth in the beginning to run the business. Ultimately, like a deck of cards, the financial foundation was not strong enough to support the actual operations.
Let’s drill down in the actual assets and liabilities.
(For the moment, I will steer clear of certain accruals, such as prepaid expenses. If you are using a simple system, you probably expense them immediately. But I can spend time with you on accruals and the matching principle in accounting; just drop me a note.)
Current assets – The pure definition is those assets which can convert to cash within one year. Accounts receivable and inventory (besides cash and near cash items) are the most common assets in this category. However, you definitely need to monitor the “turn” for these assets. The underlying liquidity is critical as you convert these into cash, which ultimately funds your business.
Current liabilities – Again, become due within one year. The most common are accounts or trade payable and current portion of long term debt. These are your creditors, and you must be able to pay them timely from operations.
Working capital – Strictly a mathematical formula, subtracting your current liabilities from your current assets. This is the fuel that runs your engine daily. It also affords you the opportunity to make new business investments, such as a new product line or added inventory.
Current ratio – This is current assets divided by current liabilities. If it is not more than 1:1, you will be facing financial pressure to meet your liabilities timely. (No working capital.) And the underlying components also play a factor. If your liabilities are due sooner than your assets can convert, you probably already feel the pain.
It is important that you calculate your cash flow forecasts in order to anticipate the urgency of the needs.
Long term assets – These are primarily your fixed assets, such as auto, furniture, and fixture, and in the unlikely and unfortunate event you own the corporate real estate, the land and building. Why do I say unlikely and unfortunate? If you are undercapitalized, and you purchased the real estate, at some point you had to cough up the down payment. That is (or more importantly was) part of your current assets and working capital. If you have a real cash crunch, you can’t pay an invoice with the equity in your real estate. It may have seemed like a good idea at the time, however it did not stand the test of time.
Long term liabilities – These are the debts that should correspond to long term assets.
If you are short of capital, there are only a few good ways to remedy the situation. Profits are the best way. Raising capital by injecting personal cash is another. Disposing of liquid assets may be another way. Just borrowing, regardless of the source, does not cure the situation.
Please take the time to understand your financial health. Then focus on your P&L and cash flow.
A 1975 graduate of the Wharton School at the University of Pennsylvania, Harvey enjoyed a 20+ year career in commercial banking, exercising his “golden parachute” in 1996. In his volunteer life, he is a past chair of the Small Business Banking Unit of the American Bankers Association, Easter Seal Society of New Jersey, the SAAGNY Foundation, PPAF EXPO, and Supplier Committee of PPAI. He is also a past President of PPAF. PPAI awarded him the H. Ted Olson Humanitarian Award in 2013.