When we discussed the basics of a balance sheet, we likened it to a snapshot of a company's financial position: what a company owns and owes at a particular point in time.
The most important element of a good photo is the ability of the photograph to communicate with the viewer. It should be able to tell a story through its composition, lighting, and most importantly its subject matter.” ---Dario Endara, photographer
Take a look at your balance sheet. Are you happy with the way everything looks? Are there a few blurry areas that you wish were a bit clearer and in better focus? What story does it tell about your business?
Let's adjust some settings in order to bring certain areas into sharper focus. These three analyses will show you a more complete story of the financial health of your business.
1 - Calculate your Current Ratio.
The current ratio is a liquidity ratio that measures your business's ability to pay back its short-term debt.
Current Ratio = Current Assets / Current Liabilities
You want this ratio to be above 1. According to Dawn Fotopulos in her book Accounting for the Numberphobic: A Survival Guide for Small Business Owners, this will guarantee you "sleep-filled nights and stress-free days."
If your current ratio is less than 1, take it as a warning that your business may not have the cash to pay its debts as they come due. Instead of facing sleepless nights and stressful days as you wonder where the cash will come from to pay your bills, you can begin to remedy the situation NOW. Let's zoom in on one of the current assets - accounts receivable - to see how it affects your cash situation.
2 - Calculate your Accounts Receivable Turnover Ratio.
The accounts receivable turnover ratio is an efficiency ratio that measures how well a business manages the credit extended to customers.
Accounts Receivable Turnover = Yearly Credit Sales / Average Accounts Receivable
Let's break it down into 3 steps:
1. Determine your total credit invoices for the prior year.
In QuickBooks Desktop, go to Reports > Custom Reports > Summary. When the "Modify Report" box comes up, change the Date Range to "Last Fiscal Year." Then go to the "Filters" tab. Under "Filter," choose "Transaction Type" and then select "Invoice" in the dropdown menu.
Do not include sales receipts where you were paid at the time of the sale - you never extended any credit to those customers. You will use the "Total Income" line as the numerator on the equation above.
Note: You can run the data for any time period, such as the prior month, prior quarter, etc - just change the report date range as needed.
2. Calculate your average accounts receivable.
In QuickBooks Desktop, go to Reports > Customers & Receivables > A/R Aging Summary. Change the dates to "Last Fiscal Year" and note the total amount at the bottom. Then, change the date on the report to the beginning of the prior year and refresh the data. To get the average, add together the amounts from the beginning and end of the year and divide by 2.
3. Divide yearly credit sales (step 1) by average accounts receivable (step 2).
If your A/R Turnover is close to 12, great job! It means that, on average, your customers are paying you within about a month of you invoicing them. If your A/R Turnover is less than 12, it means that your customers are taking longer than a month to pay you.
Let's walk through an example, assuming we have already pulled the necessary reports from QuickBooks.
Total credit invoices for the prior year = $1,000,000
Accounts receivable balance at beginning of prior year = $100,000
Accounts receivable balance at end of prior year = $120,000
Average accounts receivable = $100,000 + $120,000 / 2 = $110,000
Yearly credit sales from step 1 / average accounts receivable
$1,000,000 / $110,000 = 9.09
An accounts receivable ratio of 9.09 means that it takes our credit customers over a month to pay us.
Another way to look at this is to determine the average number of days for your customers to pay.
Take the number of days in the period you calculated (365 if you used a year) and divide by the accounts receivable turnover ratio you calculated in step 2.
Using our example from above:
365 / 9.03 = 40.42 days
Further proof that it takes our credit customers over a month to pay us.
If you want to increase your cash balance, collect on those Accounts Receivable!
Having your assets in cash instead of receivables can help you to meet your liabilities as they come due.
- Create and send invoices in a timely manner.
- Follow up on accounts past-due.
- Send reminders or statements.
- Make phone calls
- Shorten your terms.
- For example, if you previously expected payment in 30 days, consider moving to 10 or 20 day terms.
Not quickly collecting those accounts receivables costs your business in the long run.
The Harvard Business Review determined that 1.82% of receivables at 30 days will remain uncollected. At 60 days, 9.2% remain uncollected. By 90 days past due, 17.74% will never be paid. And at 120 days past due, 26.71% of uncollected receivables may as well be written off. That's a significant chunk of change that may never end up in your bank account!
Therefore, consider offering your customers the option of paying by credit card. Many business owners are turned off by the 1.7%-3.5% of processing fees that credit card companies swipe off the top of the sale. However, not having to go through the hassle of collecting on those sales will save you time and energy in the long run, not to mention cash.
3 - Look at a Comparative Balance Sheet.
As we've mentioned, the Balance Sheet is just a snapshot of where your finances stand at the moment. However, seeing where you've been over the course of the previous months or years can provide you insight into the direction you're headed for the future.
Pull a Comparative Balance Sheet in QuickBooks.
In QuickBooks Desktop, choose the Balance Sheet Summary, change the Dates to "All" or "This Fiscal Year" and then change "Show Columns" at the top of the report from "Total" to "Month" or "Year," if you're looking at a longer time frame.
In QuickBooks Online, change the Report period selected to "All Dates" or "This Fiscal Year" and then change "Display columns by" to "Months" or "Year" and run the report again.
Depending on how long your business has operated, you may see a lot of data. Start by asking these questions:
- Are payables growing? Is there an explanation for why?
- Is cash trending downward? Why is that?
- Observe what's happening with Retained Earnings, or Owner's Equity.
- Retained Earnings, or Owner's Equity, shows cumulative profits of the business over time minus any owner/shareholder distributions that have been taken. If you see growth, you can be assured that the distributions you're taking are within the limits of your company's profits.
- If this area remains a bit of an enigma to you, watch for another post where we will help you to understand how to interpret this section of the balance sheet!
Take the time to bring certain areas of your balance sheet into focus. Run the analyses on the numbers. Get clear about what story the numbers are telling. You will feel more confident about the health of your business now and in the future.
If you want a pair of fresh eyes to look over your financials, get in touch with us - we're always happy to help!