Everybody’s business — Financial statements powerful asset

By Sandra Taylor-Sawyer

As 2006 comes to an end, it is a good time to reflect on past accomplishments, future endeavors and failures.

Yes — failures. Failures can build or weaken a business depending on the step taken immediately following the mishap. That step should be to get up and not lie down waiting for the next mishap to occur.

One important first step is to begin a concise review analyzing why the failure happened and what tools are needed to prevent or minimize future adverse events. A common mistake owners of small businesses make is failing to monitor their financial position, according to “Five Keys to Financial Success” (Management Advisory Services, 1992).

A critical element to beginning the review process is a thorough examination of financial statements. All businesses should have monthly or at least quarterly financial statements prepared and reviewed. Waiting to prepare financial statements until the end of the year for presentation to a lender or Internal Revenue Service is not a good business practice.

There are two primary financial statements: the balance sheet and the income statement, also called profit and loss statement or statement of revenue and expenses. In addition, the statement of cash flow should be compiled.

Most small-business owners do not review their balance sheet. The balance sheet is packed with information the small-business owner should review before buying equipment, hiring employees, expanding the customer base, extending credit or advertising. The statement provides a snapshot of the business’ financial status or health. The balance sheet documents assets, liabilities and owner’s equity transactions typically conducted on a daily basis.

Assets of a business are best described as what the business owns. These items may include but are not limited to cash, equipment, land, inventory, accounts receivable, patents and vehicles (this is not an all-inclusive list).

Assets are the first items appearing on the balance sheet in the order of most liquid. “Liquid” or “liquidity” means the quickness of converting the asset to cash.

Liabilities are the next items listed on the balance sheet. Liabilities represent the debt of the business. Liabilities can be informal or formal claims. A written contract such as a promissory note is considered a formal claim. An informal claim will be items purchased from a vendor with a verbal agreement to pay at a later date. Liabilities also represent how much of the business is owned by creditors and not the business owner. Examples of liabilities are accounts payable, taxes payable, salaries and wages payable, notes payable and interest payable.

The final item on the balance sheet exhibits the ownership interest of the owner, known as owner’s equity or net worth. Net worth is increased by cash injections made by the owner and profits of the business (net income). It is decreased by cash withdrawals and expenses of the business (net loss).

Once the balance sheet is prepared, a comparison against previous balance sheets should be conducted. If net worth decreases dramatically from one period to the next, there may be a problem that will warrant further review.

Another tool used to analyze the balance sheet is financial ratios.

There are several financial ratios business owners should use on a regular basis when analyzing a balance sheet. One is the current ratio. The current ratio is computed by dividing the total of current assets by the total current liabilities. The word “current” represents items that will convert to cash or be paid within a year. If the current ratio number is computed to be “1.30,” it means the business has $1.30 to pay for every $1 in current liabilities. If the current ratio is lower than “1.00,” it means a business cannot fulfill its short-term obligations using assets.

A lower current ratio does not mean an end to the business. However, it is one of those red flags that should be investigated.

Next month’s column will continue the discussion with information about the debt-to-equity ratio as well as other financial ratios used to analyze the financial condition of a business. In addition, I will also address the income statement.

Sandra Taylor-Sawyer is director of the Small Business Development Center at Clovis Community College. Call the center at 769-4136 or visit
www.nmsbdc.org/clovis