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Healthy balance sheets and why they matter

BlogEnterpriseYour business By Duncan Khoury – 13 October 2020

A healthy balance sheet is the sign of a strong business. It paints a story of where it’s been, where it is today, and how it’s prepared for the future. A healthy balance sheet is a critical financial report when it comes to securing business financing, it highlights the strength of your business and its ability to weather any economic storms. And given the uncertainty that still lies ahead, along with a detailed pandemic contingency plan, it’s never been more important. 

Why is a healthy balance sheet important?

A healthy balance sheet is about much more than a statement of your assets and liabilities: it’s a marker of strength and efficiency.

It highlights a business that has the optimal mix of assets, liabilities and equity, and is using its resources to fuel growth. With the right mix and a positive net asset position, a business is in a much stronger position to succeed. 

But before we get into the details of what a healthy balance sheet looks like, let’s get back to basics. 

Back to basics – what is a balance sheet?

In the simplest terms, a balance sheet is a statement of a company’s assets, liabilities, and equity at a particular point in time. This can include:

  • Assets: cash, inventory, machinery, property
  • Liabilities: accounts payable, loans (bank/finance), taxes, shareholders loans (in/out), customer prepayments/deposits, accrued expenses
  • Equity: retained earnings

The balance sheet is a key financial statement that’s used to help assess the financial health of a business.

Structured around the basic accounting equation where assets are on one side, and liabilities with shareholder equity on the other, balance sheets contain important information to help calculate key financial ratios. Think of it as a snapshot of your company’s financial health at a given point in time.

What’s considered a strong balance sheet?

There are few tell-tale signs of a strong business, and a strong balance sheet is where you can generally find them. Not sure what’s considered ‘strong’ or ‘healthy’, or what to look out for? Here are some key indicators.

A positive net asset position

A positive net asset position is a measure of how a business is performing. This highlights whether a business is profitable and whether these profits are being reinvested back into the business. Companies with a positive net asset position are better able to sustain themselves during tough economic conditions and can make attractive candidates for working capital financing. 

The right amount of key assets

Assets work best for a company when they’re actively providing value. For example, too much inventory can be a sign that stock isn’t moving quickly enough and highlights an inefficient use of cash. A low number of ‘stock in hand’ days, however, can be a sign of a well-managed asset and a business that’s getting this balance right, pending the specific industry of course. 

More debtors than creditors

Having more money owed to your business than your business has owing is a sure sign of a healthy balance sheet. In fact, it’s one of the key indicators that your business is solvent. However, it’s necessary to take a deeper dive to understand inflated positions on your debtors and/or creditors. Ask yourself: 

  • What terms are you offering your customers? 
  • What terms have you been granted by your suppliers? 
  • What is the ageing on the receivables and payables? Poor ageing on the receivables may signal invoicing issues or customers not paying on terms. Stretched creditors could reflect a cash flow issue in the business. 

Your debtors and creditors are key assets and liabilities in the business balance sheet. It’s critical they are nurtured based on this level of importance. 

A fast-moving receivables ledger

Slow-paying debtors can strangle the cash flow of a business. Ideally, cash flow would be moving relatively quickly. If not, this could be an area worth looking into. Why not consider early payment discount advantages or Debtor Finance?

Need a quick snapshot of your cash flow? Here’s how to calculate your working capital from your balance sheet: Working capital = current assets – current liabilities.

A good debt-to-equity ratio

Having a good debt-to-equity ratio means your company has enough shareholder equity to cover debts. This is especially important in the event of an economic downturn.

Can your business cover its debts in the event of a downturn? Here’s how to calculate your debt-to equity ratio from your balance sheet: D/E ratio = total assets/total liabilities. 

A strong current ratio

Sometimes known as the ‘liquidity ratio’, the ‘current ratio’ is determined by dividing the business’s current assets by its current liabilities. This ratio is a key indicator of liquidity as it determines the business’s ability to pay its short term liabilities with its short term current assets. When calculating the ratio, anything less than 1 is an indicator that the business may have a liquidity issue. This is not itself a sign that the business is about to collapse however. It actually alerts the business that it’s in need of additional liquidity, such as Trade or Debtor Finance, to close the cash flow gap. 

Why is it smart to have a healthy balance sheet?

A healthy balance sheet reflects an intelligent business – a business where there is the right balance between debt and equity, and the management team is using debt to propel the business forward. 

One of the key indicators of a smart business is how effectively it uses its resources. While having assets is undoubtedly a positive, having too much equity tied into your cash isn’t necessarily a sign of an efficient business. Shareholders are primarily looking for a higher return on their investment, and to do this their funds need to be put to good use. 

Using debt to invest in more acquisition-generating and brand-building activity is a key consideration when assessing the strength of a business. It’s an efficient way to manage resources and shows confidence in the future growth of the business. With the right mix of debt and equity, you can invest in activity to grow revenue and profitability. And that’s where you can hit the sweet spot.

Ways to make your balance sheet healthier

If you’re looking to create a healthier balance sheet for your business, there are some tried and tested tactics that you can explore. You can:

  • Improve your inventory management. The cost of holding onto stock is high! If you have stock that isn’t moving or is obsolete, look into ideas to move it out the door. Consider sales, discounts or promotions to help turn the stock into cash that can be re-invested elsewhere. Untried distribution channels, including online marketplaces and platforms could be a genuine option also.
  • Review your collection procedures. Are your debtors taking too long to finalise their payments? If so, this is costing you and impacting your balance sheet. Reviewing debtor payment terms, offering early payment discounts or reviewing your systems can be some ways to help bring down your debtor days. It may be a good idea to read our tips for improving debtor management
  • Assess non-income producing assets. Are these assets providing value to your business or are they just ‘lazy’ assets? If they aren’t being used to generate income or don’t have the potential to do so, selling them can be a quick way to pay down debt and improve your balance sheet.

By looking into these parts of your business, you can make some significant changes to the way you operate and improve the strength of your balance sheet. This means when you’re in a position to secure more finance, you’ll be better prepared.

Your balance sheet and securing finance

Are you looking to secure finance to help grow your business? Now that you know the importance of a strong balance sheet, it’s important to know that what healthy looks like will depend on the type of finance you’re looking to secure. Octet offer two primary sources of supply chain finance – Trade Finance and Debtor Finance. This is what we generally consider when providing finance under each facility:

Trade Finance

Trade Finance works as a line of credit businesses can access to help pay suppliers. There are a few key indicators we consider when assessing Trade Finance, which revolve around the financial health of the business. This means reviewing current and historical financial performance, as well as obtaining insight into the Balance Sheet position.

We also consider:

  • What is the net tangible asset position? This will help determine lending capacity and the resulting credit limits.
  • What levels of inventory does your company hold and what is the turnover? A quick turnover indicates efficient stock management and healthy cash flow.
  • What equity or loans have the shareholders of the business introduced or taken out?
  • What are the carried forward profits or losses of the business?

Want to know what other eligibility criteria we consider? Read about our Trade Finance facility here.

Debtor Finance

With Debtor Finance, receivables are used as collateral and, with confidential Debtor Finance, we also take control over the debtor’s receipts. As a result, we consider a broader range of factors when assessing suitability, including:

  • What do your receivables look like? What is the spread of debt, the age of the receivables ledger, and who are the debtors?
  • Does your industry have a clear sales process, with clear proof of delivery or hours performed?
  • Is your business trading profitably? If not, what initiatives are in place to improve the situation?

Want to know what other eligibility criteria we consider? Read about our Debtor Finance facility here.

Want to know if your balance sheet is healthy?

Get in touch. And make sure to read our tips for improving debtor management too. 

 

 

Disclaimer: The following comments are only our views and should not be construed as advice. You should act using your own information and judgment. Although information has been obtained from and is based upon multiple sources the author believes to be reliable, we do not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute the author’s own judgment as at the date of publication and are subject to change without notice.