If you needed to make a quick assessment of a small business’s health, but could only ask a few questions. What would you ask? Everyone will approach this differently based on their own experience.
Two potential questions are -“How much cash do you have on hand?” or “How much money did you make last year?”
But what does a high cash balance tell us if Accounts Payable is usually high or behind? And when we ask how much money, do we mean revenue, profit, accrual-based, cash-based?
When I am onboarding a new client, the first question I ask is, “What is the balance in your equity accounts?” My goal is to dive right into the business balance sheet. Though the income statement is a good look at a company over a specific period of time, the balance sheet, and especially the equity balance, is a great overall indicator of a company’s health.
Here’s a simple, although imperfect, analogy. If you want to know how healthy someone is, you can ask them how many minutes they exercised yesterday and then draw a conclusion. Maybe they ran a marathon, or perhaps they sat on the couch all day. Neither would give you a complete picture of the person’s overall health. But if you ask something like, “What is your resting heart rate?” the answer will get you closer to a better understanding of his fitness.
A balance sheet is like a resting heart rate. In it, we can see the impact of all decisions made throughout the business’s life. One highly successful year on a revenue basis does not necessarily make a healthy company. The balance sheet will reveal all.
My overall goal in helping a new client is to see if there is a gap between what the financial reports say versus what the owner thinks about his company’s financial strength. The owner’s intuitive feel for the amount of retained earnings in the company should match what is recorded on the most recent balance sheet.
The equation that governs the balance sheet is: Assets = Owner’s Equity less Liabilities.
The assets are on the left of the balance sheet, and liabilities and equity on the right. This set-up is why we get a complete picture of the entire company, including cash on hand, equipment, Accounts Receivable, Accounts Payable, Loans Payable, Depreciation, and owner’s investment. Every prior accounting period will have left its imprint, good or bad, on these accounts.