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FOOD FOR THOUGHT

What does a strong balance sheet look like & why is it important?

Posted by Ash Clarke on June 03, 2016

Businesses with strong balance sheets are more likely to survive economic downturns and be ready to thrive when the going gets good again. So what does a strong balance sheet look like, and how can you take steps to strengthen yours?

 

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A strong balance sheet goes beyond simply having more assets than liabilities. Entities with strong balance sheets are those which are structured to support the entity’s business goals and maximise financial performance.

 

Strong balance sheets will possess most of the following attributes: intelligent working capital, positive cash flow, a balanced capital structure, and income generating assets.

 

Let’s take a look at each feature in more detail.

 

 

1. Intelligent Working Capital

A strong balance sheet will utilise an optimal level of working capital (current assets less current liabilities) to fund the business’ core operations, with the end goal of driving revenue and subsequently profit. It’s important that a business understands what that optimal level is. The trick here is to strike a balance between liquidity and profitability which are often conflicting strategies.

 

Having too much funds tied up in stock will strangle your cash flow and reduce your ability to meet financial obligations as they fall due. Having too much cash sitting in the bank could be coming at a massive opportunity cost to the business and be better utilised investing in higher income-generating assets, paying off debt or distributing to shareholders/beneficiaries. Too many business owners neglect to review their working capital requirements periodically.

 

 

2. Positive Cash Flow

Although this is a part of working capital it is so important to a business that it requires its own section. Cash, also referred to as ‘business oxygen’, is the most evidential sign of a strong balance sheet. Your business cannot breathe without cash flow. All businesses need cash to achieve their short term goals - to pay employees, trade payables and a host of other expenses. It’s therefore vitally important to manage cash flow through forecasting, budgeting and the use of variance analysis.

 

A sign that a business is doing well is one that regularly maintains a minimum cash reserve for rainy days/protection. A mix of historical analysis and future focus will assist your business in managing its cash flow and achieving its short term goals.

 

Read more: How a good accountant can help minimise tight cash flow

 

 

3. Balanced Capital Structure

A strong balance sheet will employ a balanced mix of debt and equity funding to maximise the return on capital employed. Debt in many cases is a cheaper source of financing – interest is deductible and shareholders often require a higher return on their investment. However, taking on debt always poses some risk – it can be rewarding when times are good but dangerous when there is a downturn.

 

Because of this risk, managing banking covenants becomes imperative. Equity financing can be more expensive but is considered less risky as there is no obligation to repay periodically. Entities with strong balance sheets retain enough earnings to fund growth and achieve business goals while distributing excess funds to beneficiaries. Often strong balance sheets are the result of borrowing debt at a ‘good’ time, (for example right now when interest rates are very low). Of course, every business is different, and it’s a good idea to seek expert financial advice before you make any long-term decisions. Balance is crucial.

 

 

4. Income generating capital assets

A business requires suitable capital assets to generate revenue, with some entities more capital intensive than others. Management should invest in assets which will assist the business in achieving its financial goals. These capital assets must be reviewed regularly, and if they are not performing then move them on and invest in those which are .

 

 

Strengthening your balance sheet

There are numerous reasons why a business might not have a strong balance sheet - poor financial performance, taking on unserviceable debt, stripping too much money out of the business… the list goes on. If you are the not so proud owner of a fragile balance sheet then you should engage a business advisor to get to the root of the problem before it’s too late. A good advisor will do three things: identify the causes of the weak balance sheet, suggest processes and actions for improvements, and enforce accountability.

 

In the meantime, here are some tips on how you can improve your balance sheet:

  • Improve inventory management. If you trade in goods, review your inventory levels immediately. If stock is obsolete, then shift it out the door – the cost of holding onto it could be more than you think.
  • Review your procurement strategy. Do you have a purchasing schedule for the year, and is it being adhered to? Are you buying too late and missing out on seasonal sales? Make sure someone is responsible for this function of the business and plan, plan, plan - a forward focus is crucial.
  • Look at the collection of your receivables. Are slow-paying debtors slowly strangling your business? You might need to implement a more aggressive collection strategy to ensure you get paid on time.
  • Sell lazy and unproductive assets. If assets aren’t generating a healthy return – and likely never will – then sell them on. Conducting financial ratio analysis is a great way to determine whether your business is using its assets effectively. You may want to look at leasing assets rather than purchasing them – this could be cheaper than owning, particularly for assets which date quickly such as those in the technology sector.
  • Maintain a forward focus. Always ask yourself, what’s around the corner? What are the threats to your current position? What strategic plans should you make for the future? Your balance sheet should reflect your business strategy.

 

Taking steps to strengthen and maintain a strong balance sheet will help your business thrive during even through the toughest of times. It also decreases the risk of failure.

 

Growing a business can be expensive, but a strong balance sheet will serve as a foundation from which you can launch into new products and markets. Not to mention bankers love nothing more than seeing a solid balance sheet with healthy cash reserves and a balanced capital structure when assessing loan applications.

 

Overall, a strong balance sheet will make you more agile and give you options to shape a more profitable future.

 


 

Keen to gain a better understanding of financial management in your business? Download our Financial Statements Guide for Business Owners, which includes a description of useful financial ratios, what they mean in layman’s terms and, of course, how to calculate them.

 

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Topics: Financial Reporting, Financial Management