A Budget Balancing Act
When financial planner Edward Bao sits down with business owners, his overarching question is, “How do you keep yourself flexible for something unexpected to happen?”
The reality is, the success of small businesses can be determined by whether or not the owner is in debt or has debt, he says, and how he or she plans for those unforeseen circumstances.
For shop owner Sean Sabin, paying close attention to his balance sheet numbers saved his business.
During the first two years of Sabin’s Body Shop being open in Gothenburg, Neb., the staff was stuck in a situation where thousands of dollars were spent, but in the end, the money was just not coming in to cover the purchases and bills being paid. Sabin says, in total, the shop lost roughly $30,000 in the years after he and his father, Randy, opened the shop in 2012.
So, Sabin turned to a financial advisor and dived deeper into his financial statements. One of the most important components was his balance sheet, he says.
While the balance sheet is a specific snapshot in time, there can be ebbs and flows to the financial state of the business, says Bao, representative for the Financial Planning Association of New Jersey. He says the bottom line of a balance sheet is to determine the business’s cash flow.
Sabin has reached a point today where he can rely on the bottom number of his balance sheet and believe that it will positively affect cash flow.
“I can rely on that number because I’ve done my homework on other stuff,” Sabin says.
Sabin and Bao outline the five steps every shop owner needs to take to effectively interpret his or her balance sheet.
Step #1: Understand the sheet.
The concept of the balance sheet is to give a business owner a value of his or her net worth, which is comprised of assets and liabilities, Bao says. Assets are things that are owned and have a tangible value and liabilities are debts of things a shop owner owns.
Bao says an owner should never guess at the amount of money coming into the business. It is critical for an owner to know what is owed versus what is owned in the business.
He says the owner should either take time to learn the makeup of the balance sheet or seek advice from an accountant. He also says a helpful tool in understanding the sheet is to use an online accounting book like QuickBooks.
Step #2: Plan time to look at the sheet.
An owner should sit down every month or at least quarterly to take a look at the balance sheet, Bao says. While the sheet may show numbers for a specific snapshot of time, if understood correctly, the balance sheet could also show trends and offer reasons for why the business is acting a certain way.
For example, if the shop is working with three insurance companies and one company tends to pay later than the other, then that could affect accounts receivables on the sheet. For example, if the shop is really busy the month of June and the team has repaired a lot of cars, but the receivables category is 25 percent higher than normal, the shop may have done more work with the insurance company that takes longer to pay. Taking time to understand how and why the number changed can make a difference, he says.
Sabin spent six months in which he sat down with a financial planner and looked at the sheet, he says. Sabin and his advisor met on a weekly basis so he could learn what each number means in the overall picture.
Step #3: Determine the most important categories.
Bao says the top four categories to pay attention to include debt to equity ratio, current ratio, quick ratio and working capital.
Debt to equity ratio can be a red flag if something is wrong financially, he says. Current ratio shows how much cash flow the business currently has. Quick ratio is similar to current ratio but without the inventory in the calculation because inventory cannot necessarily be taken and converted to cash easily, Bao says. Working capital gives the owner a number of what he can use for purchasing for the business.
Sabin says he makes sure to take a look at accounts receivables, inventory and accounts payable. He says he looks at the accounts receivables to make sure he knows what people owe and that he doesn’t spend money the shop does not have. Inventory needs to be monitored closely to prevent the shop from over ordering parts. Accounts payable shows how much he has in outstanding debt.
“I used to have a folder of bills that were due but now I know I need to pay bills twice per month,” Sabin says.
Step #4: Learn how to calculate.
Data that is on the balance sheet is typically taken from the business income statements, profit statements and law statements, Sabin says.
1. Debt to Equity Ratio: This is what is owed to what is owned. Bao says a lower ratio number is usually more favorable in most industries.
How to calculate: Divide the shop’s total liabilities by the shareholder’s equity, Bao says. For example, if someone bought a $100,000 house and took a loan out for $50,000, then that person has a 50 percent debt to equity ratio. The higher the number, the less of the business the person owns.
2. Current Ratio: The current ratio determines how much cash the business has for short-term bills, Bao says.
How to calculate: This is the current assets divided by the current liabilities. A good ballpark ratio is 1.5 or 2, Bao says. The higher the ratio, the more the owner is accumulating cash for the short term bills.
3. Quick Ratio: The quick ratio determines how much cash the business has for short-term bills but does not take into account the inventory numbers, Bao says. Inventory is more long term and therefore will not help in regard to short-term bills.
How to calculate: The current assets divided by the current liabilities. Current assets should not include inventory.
4. Working Capital: The working capital metric will determine if the owner is buying on favorable terms, Bao says.
How to calculate: Current assets minus current liabilities.
Step #5: Make an informed decision.
Sabin says after he has gone through his steps and done his “homework,” he relies on the bottom number of the balance sheet. He most often looks at the profit and cash flow projections.
Sabin knows his business needs roughly $20,000 to operate effectively and out of his current profit, most amounts need to be approved by insurance or already have approval. He says he knows to expect that money within 7–10 days and will not use the money in the meantime.
While a zero on the balance sheet may look good, Bao says owners need to know when that could potentially hurt your business. And, having a zero in the debt to equity ratio might mean the owner is using too much of their own assets as a leveraging and purchasing tool.
The debt to equity ratio can affect whether a shop owner can purchase new equipment and take on more debt to do so, show if the debt can be restructured more favorably for the health of the business and determine if there needs to be a new process on getting paid to reduce receivables.
Businesses are each structured uniquely but if any of the numbers are in a “red” zone, Bao says the owner can look toward adjusting carry cost, accounts receivables or reducing expenses.
“Obviously the money you take out of the business as a shareholder or owner means you’re working toward gaining something of value back,” Bao says.