A strong balance sheet and why it's important
Henry Ford once said, “The two most important things in any business do not appear on the balance sheet: they are its reputation and its people.” Nevertheless, a balance sheet is an essential financial statement for any business. It is crucial to understand what appears on a balance sheet and what it can tell you about your business.
Businesses with a strong balance sheet are more likely to survive economic downturns and be ready to thrive when times improve.
A strong balance sheet goes beyond simply having more assets than liabilities. Entities with a strong balance sheet are structured to support the business objectives of the entity and maximize financial performance.
Strong balance sheets typically exhibit most of the following characteristics: intelligent working capital, positive cash flow, a balanced capital structure, and income-generating assets.
1. Intelligent Working Capital:
A strong balance sheet will use optimal working capital (current assets minus current liabilities) to finance the core operations of the entity, with the goal of increasing revenue and subsequently profits. It’s crucial for a business to understand what the optimal level is. The challenge here is to strike a balance between liquidity and profitability, which are often conflicting strategies.
Having too much tied up in inventory, for example, can choke your cash flow and reduce your ability to meet financial obligations. On the other hand, having excess cash in the bank might represent an opportunity cost, and it could be better utilized by investing in higher-yielding assets, paying down debt, or distributing it to shareholders or beneficiaries. Many business owners neglect to regularly review their working capital requirements.
2. Positive Cash Flow:
Although it’s part of working capital, cash flow is so critical for a business that it warrants its own focus. Cash, often referred to as “business oxygen,” is the most obvious sign of a strong balance sheet. Your business cannot operate without cash flow. All businesses need cash to meet short-term objectives, such as paying employees, trade debtors, and various other expenses. Therefore, managing cash flow through forecasting, budgeting, and variance analysis is of utmost importance.
3. Balanced Capital Structure:
A strong balance sheet will use a balanced mix of debt and equity financing to maximize the return on capital employed. Debt is often a cheaper source of financing (interest is tax-deductible), and shareholders often require a higher return on their investment. However, debt always carries a level of risk; it can be rewarding when times are good but perilous when there’s a downturn.
Due to this risk, managing bank covenants is essential. Equity financing may be more expensive, but it’s considered less risky as there’s no obligation for periodic repayments. Entities with strong balance sheets retain sufficient earnings to fund growth and meet business objectives while also distributing excess funds to beneficiaries. Often, strong balance sheets result from taking on debt at the right time (e.g., when interest rates are very low). Every business is unique, and it’s a good idea to seek expert financial advice before making long-term decisions. Balance is key.
4. Income-Generating Capital Assets:
A business requires suitable capital assets to generate income, with some entities being more capital-intensive than others. Management should invest in assets that help the business achieve its financial objectives. These capital assets should be reviewed regularly, and if they are not performing as expected, they should be divested.
Strengthening Your Balance Sheet:
There are numerous reasons why a business might not have a strong balance sheet – poor financial performance, unsustainable debt, excessive distributions to owners – the list goes on. If you find yourself in possession of a fragile balance sheet, it’s advisable to consult with a business advisor to address the root cause before it’s too late. A good advisor will do three things: identify the causes of the weak balance sheet, propose processes and actions for improvement, and enforce accountability.
Meanwhile, here are a few tips on how to strengthen your balance sheet:
– Improve inventory management: If you deal with goods, review your inventory levels immediately. If inventory is aging, sell it off – the cost of holding it may be higher than you think.
– Review your procurement strategy: Do you have an annual procurement schedule, and is it adhered to? Are you buying too late and missing out on seasonal sales? Ensure someone is responsible for this function in your business and plan, plan, plan – forward focus is cardinal.
– Examine your debtors’ collection: Implement a more aggressive debt collection strategy to ensure you get paid on time.
– Identify and sell unproductive assets: If assets are not providing a healthy return, and they likely never will, then sell them. A financial ratio analysis is an excellent way to determine if your business is effectively managing its assets. You may also want to consider leasing assets rather than purchasing them, especially for rapidly depreciating assets such as those in the technology sector.
– Reduce personnel costs: In the early stages of establishing a business, personnel costs can represent a significant portion of operating expenses. By only hiring an appropriate number of staff, your business equity can get a boost. You can gradually increase staffing as your business grows, rather than anticipating a future upturn.
– Maintain a forward focus: Always ask yourself, what’s around the corner? What are the threats to your current position? What strategic plans do you need to make for the future? Your balance sheet should reflect your business strategy.
By taking steps to strengthen and maintain a strong balance sheet, your business can thrive even in the toughest times and reduce the risk of failure. Not to mention that lenders love to see a solid balance sheet with healthy cash reserves and a balanced capital structure when evaluating loan applications.
In general, a strong balance sheet makes your business more agile and provides options to shape a more profitable future. For more information on how to manage your balance sheet effectively, feel free to contact our team of experts by sending us an email at info@crs-group.co.za or by calling us at 079 495 5146.