Why is the Balance Sheet Important?
In a previous lesson we had listed out all the items that appear in an ecommerce balance sheet. Now we’ll be covering exactly why a balance sheet is important to any business, be it small or big.
You’ll also get an idea of the various applications for this highly significant statement so that you can have a better grasp on how relevant it is to your business. Let’s begin by refreshing your memory:
What is a balance sheet?
It is a statement that reflects the company’s financial standing at any given point in time. The balance sheet lists out all the assets (what the business owns), liabilities (what the business owes) and equity (the difference between the two) so that you can determine the true net worth of your business.
Disregarding the balance sheet:
While a lot of small businesses prepare financial statements at the end of every year or period, these are generally set aside and rarely looked back on by owners in the course of running day-to-day business.
However, this is a trend that can seriously affect your business adversely. Successful entrepreneurs and business owners make the most of their balance sheets and other financial statements, viewing them as a means to track growth, predict outcomes and create strategic plans.
Why your business needs a balance sheet: A quick summary
- It helps you outline your business’s true worth, offering insights into your company, operations, liabilities, assets and so much more.
- It gives interested investors and potential lenders a good idea of the company’s financial position, so that they can make an informed decision.
- The major goal of any business is to make profits. The balance sheet is one of the most important tools that aid in decision making, helping you evaluate how well your business goals are being met and what areas need to improve.
What if you own a small business?
A lot of small business owners often pursue ecommerce selling as a way to monetize their hobbies. This leads them to question whether preparing a balance sheet is really necessary.
The answer to that is: it depends. If you’re serious about growing your business or have some degree of aspiration, then you’ll definitely need to consider it. Here are some of the reasons why:
Long term growth
The balance sheet helps you grow in the long-term. No matter how small-scale your business, eventually you’ll need to note the rate at which your assets are depreciating and keep track of labor costs, if you want to claim tax deductions and make better profits. This won’t be possible if you don’t have a timely and well kept record; yet another reason why balance sheets are super important.
Pitching your business to investors
It’s also worth noting that, if you plan on selling your business, you need to be able to provide an estimate of its net worth. This has to be expressed in proper terms that showcase the business’s real value – not its potential-to investors. A balance sheet enables you to do this better than any other document.
Including all costs
Many assets have carrying costs, which take a toll on your business, without anyone even noticing. A periodically prepared balance sheet helps you determine exactly how profitable your business is after eliminating such costs.
Eg: real estate properties that don’t appreciate faster than your country’s inflation rate add to your carrying costs.. Another example is any vehicle asset since, in addition to maintenance costs, it loses value every year. However, depreciation is good for claiming tax deductions which is yet another reason why you need a well-maintained balance sheet to show these expenses.
Key benefits of having a periodically kept balance sheet statement
Keep interested parties well-informed
You can learn a lot about your business and its financial health from the balance sheet. This information can be used to guide your internal management decisions. Additionally, it helps report your financial status to interested lenders, investors and shareholders.
Spot problems ahead
Regularly keeping track of your finances can help you identify any issues or discrepancies before they become full-blown problems. For eg: consistent balance sheet reports help you ensure that your business isn’t suffering from a lack of cash flow, which happens to be a major cause of failure for many small businesses.
Determine risk and return capacity
By monitoring your current and long-term assets, you get a good grasp of your ability to generate cash flow and sustain business operations.
Keep liabilities in check and grow assets
Short and long-term liabilities, on the other hand, help you prioritise your most pressing financial obligations. The more your assets exceed your liabilities, the better off your business is and the higher your net worth grows.
Keep debt levels sustainable
If your liabilities exceed the cash you have in hand, then you’ll have to borrow additional capital from another source. Such decisions are all made based on the balance sheet. This way, you can always stay up to date on whether or not your debt levels are sustainable. Thus, it helps you avoid long-term financial crises by taking action well ahead.
Assess working capital
The balance sheet is widely used to determine whether the business has sufficient working capital to continue its operations. Working capital is simply the difference between current assets and current liabilities. In other words, it helps you recognise whether the business is doing okay or running at a loss by taking on more debts than you’re capable of repaying.
Borrow capital for your business
The balance sheet is widely used when it comes to securing a business loan for your business. This is because just about any lender or financial institution relies on it to know your credit history, financial health, debt-repayment track record etc.
It also keeps investors informed about what their funds will be contributing to and when they can expect to be repaid.
Estimate real value
The balance sheet reflects your business’s true net worth in the form of difference between total assets and total liabilities. It is the amount you own from the company after deducting all liabilities. This is a very significant number for investors that are interested in securing a share in your company.
Potential for future operations
In other words, it helps you determine how sustainable your business is. This can be understood based on non-current assets and current assets. If your business owns property such as equipment, utilities, office space etc and their overall value is higher than that of current assets, then your business is very capable of continuing future operations.
Decide on the possibility of dividends
Dividends are issued when the company is making great returns and has a high rate of profit. The higher your retained earnings, the more your shareholders can make in the form of dividends. Whether or not your business can afford to issue dividends is a matter that can be identified using the balance sheet.
Key differences between the balance sheet and the income statement
Know your liabilities
Whereas an income statement can list out the revenue earned and the expenses made in running the business, it doesn’t offer any insights into the liabilities of the business,ie; what is owed.
For example, let’s say you’re an ecommerce seller and your sales are going through the roof. Now if you were to rely on the income statement alone, you would assume that your business is strong, financially. However, at this stage you haven’t yet considered the supplier invoices that your business owes, due in the upcoming weeks or months. This is why you need the balance sheet, so that you have an accurate understanding of your true financial standing, after deducting all liabilities.
Know your regular spending and lending habits
By comparing your accounts payable and receivable data across different balance sheet periods, you’d be able to arrive at a pretty clear picture of your business spending habits. Not only would you have a fair idea about regular customers you need to collect payment from, but also regular creditors to whom you owe money.
Know your inventory
The balance sheet offers you early warnings for many potential issues that could be a cause for alarm if you don’t pay attention. This includes imbalanced inventory levels, insufficient cash funds and higher debt obligations.
With regular financial reporting, you’d be able to spot the level of inventory your business holds at any given point in time. If your inventory makes up most of your assets column, it can drain your business in storage, maintenance and insurance expenses.
On the other hand, insufficient inventory can cause lengthy delays in fulfilling imminent customer requests which in turn, leads to a loss in revenue.
Bottom line
For a lot of small businesses, the balance sheet is a very important statement that offers valuable insights into the company’s financial health. By contrasting what is owned and what is owed, the statement reflects how well maintained and sustainable your business truly is.
Even the most callous investors would spare a glance or two at your balance sheet before they put money into your business. This is why, if you plan on growing your venture, you need to be ready to have accurate and updated financial reports published regularly.
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