Say Hello To Your Balance Sheet
Part 1: Assets
Bonus: 3 value-added measurements to maximize your company value.
Most landscape business owners I talk with focus most of their financial attention on their income statement. Please know that this is very common among non-financial business owners and managers. Tracking actual performance compared to the budgeted numbers makes sense as the year unfolds. IF the books are available on a timely basis, (much more often the case now, with the increased adoption of business systems software that integrates with QuickBooks, Sage, or other accounting software), action can be taken to improve revenues or reduce expenses, depending on the facts. This is wonderful! The good news is that there is another tool that will provide more insight and opportunities to improve the company’s effectiveness.
The balance sheet will provide you with more actionable information. Not only is this the place to measure whether there is sufficient cash flow to cover the payment obligations, but there are also other sources of information that will warn management about potential future problems.
Let’s review. The balance sheet shows the financial condition of the company at a particular point in time. It sums up all the assets owned by the company and all the amounts owed in liabilities. The amount owned in excess of what is owed is the Shareholder’s Equity. Just as with an individual, what we own, minus what we owe, is our net worth. Net Worth is the equivalent of the owners’ equity. So, the classic equation is:
Assets = Liabilities + Shareholders’ Equity
Most reports will offer a comparison to last year’s results for the same period. This comparison can be helpful to identify trends and manage problems proactively. Let’s get into a little more detail.
ASSETS
Are listed in several categories, usually from most liquid to least liquid. Liquidity is the speed and ease of converting an asset to cash. Gold is relatively liquid; a building or intellectual property like a trademark is not liquid. The amount of liquidity is valuable because this cash can be used to pay debts or to buy inventory. While many small business owners do maintain a large number of current assets, including cash and cash equivalents, we should not that too much cash sitting around unused is also a problem. There is a tradeoff in that if it is not invested either in the business or otherwise, it is not earning a return for the holder.
Current assets are those assets that can be turned into cash in less than a year. This includes cash and cash equivalents (money market accounts, for example) and publicly traded stocks and bonds that can be sold, and proceeds received in a few days. The other large current asset is the amount owed to the company by its customers. These are the accounts receivable. The company has performed work for the customer and is now owed money for performing that work. The amount of time it takes for the company to collect accounts receivable is an important financial measure. The Days Sales Outstanding report will show how long it takes for the company to collect its receivables. The lower the number of days, the better job the company is doing at managing its cash flow.
What to Watch
1. Current Ratio = Current Assets/Current Liabilities
To measure the amount of short-term liquidity, the current assets are divided by the current liabilities. This measures the short-term liquidity of the company. For a supplier, the higher the current ratio, the better. However, from a return on investment (ROI) perspective for the company’s owners, too much cash may be inefficient. Usually, a current ratio of at least one is considered healthy. That is not to say that less than a 1 is a bad thing, since a company may have untapped borrowing capacity that could be used for short term liability payments if necessary.
2. Quick Ratio = Current Assets – Inventory/Current Liabilities
Since the inventory is often the least liquid current asset, it may also be unreliable due to damages, becoming obsolete or losses. If there is a large inventory, the company may have overbought and may not move as quickly as another current asset. Therefore, the Quick Ratio, sometimes called the “Acid Test” is used. If the inventory amount is a large percentage of current assets, it would be more important to evaluate the quality of the inventory in terms of useability.
3. Days Sales Outstanding = Ending Accounts Receivable / Revenue/Day
This formula tells us the average collection period and receivable days. This is the average time it takes to collect the cash from sales. For example, if this company shows 55 DSO compared to its prior average DSO of 25, this will indicate a problem. Make sure that accurate billings are sent to customers on a timely basis and that accounts receivable are collected on a timely basis. (Who is responsible for this in your company? Are you tracking the reduction in DSO and paying an incentive based on improvements?) Collecting what is owed can be fundamental to the cash flow of the business. Amounts not collected over long periods of time are less likely to ever pay. There may even be the need to reserve for that “bad” debt as it becomes less collectible as time passes. Note also that DSO is a common point of evaluation for companies that are buying another company since it shows that customers aren’t paying their bills in a timely fashion.
Next week I will continue this balance sheet discussion. The topic will be Inventory and Long-Term Assets. What to watch notes will be included. You may want to look at your most recent balance sheet (year-end 2022 ready yet? And compare it to year-end 2021.) and follow along with your numbers. Questions, please give me a call.
If you would like to discuss your readiness to sell or buy another company or if you would like to explore exit planning and the various options you may have (or not have), please reach out. We can discuss when you might want to start the process, how to start, and what to look for. All of this is through the lens of the landscape industry!
You can reach me via email: [email protected] or on my cell phone a: 224-688-8838.
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