Balance sheet and debt ratios
In the Self-Assessment, we asked you this question:
- In regards to our financials, as the business owner:
- I review with my accountant the status of all ratios on a monthly basis to make sure all data is accurate, reliable, and meets our creditor requirements/commitments.
- I am very comfortable understanding the balance sheet and debt ratios.
- I am still trying to learn what the balance sheet and debt ratios tell me.
- I focus on other areas of the business and rely on my bookkeeper or accountant to advise me of any questions regarding the balance sheet or ratios.
- I feel our business model does not require us to monitor ratios or our financial statements on a regular basis. We only track what we need to know.
While the income statements represent the revenue over expenses to indicate profit or loss, the balance sheet reflects the assets, working capital, and shareholder equity of the business. Your accountant will structure the balance sheet and income statements to reflect minimum tax liabilities.
Every share sale transaction will eventually work through the process of a detailed review of the balance sheet. Most balance sheets include various forms of Shareholder Loans or perhaps investments or assets that will not be included in the transaction. In anticipation of this discussion the business owner should work with their bookkeeper or accountant to ensure the balance sheet is clean and straightforward to understand.
The Buyer will be looking for a balance sheet to represent equipment, materials, inventories, accounts receivable, and cash on hand, etc. The equity portion of the balance sheet will also tell a Buyer how the equity value of the business is being represented.
The balance sheet reflects the numbers required to complete basic ratio calculations:
- Quick ratio (cash + Accounts Receivable divided by current liabilities)
- Current ratio (current assets divided by current liabilities)
- Inventory turns (inventory value divided by cost of goods)
- Collection period (Accounts Receivable divided by month sales * 30 days)
- Payment period (accounts payable divided by month sales * 30 days)
While it is helpful (not critical) for you to understand the implications of these numbers, the Buyer and their advisors will have to understand what these ratios tell them about the business model. If you’re not prepared to address questions related to the balance sheet, you should prepare your bookkeeper or accountant to address the questions when they arise. They will!
The important fact here is to be prepared to have questions related to the ratios answered within the negotiation process. They are a critical part of a Buyer assessing the financial model for your business. Business owners who are prepared to share detailed balance sheet calculations help to generate confidence for the Buyer they are purchasing a business with reliable financials.
As the business owner you may decide to rely on your bookkeeper or Accountant to manage the financial documentation for the financials. As the primary RISK TAKER as the business owner you need to invest energy and time to develop a basic confidence in what your financial statements tell you monthly.
- Print out your last 6 months (month by month) set of statements. Place them side by side so you can read them all at the same time.
- For each category or line item, read across the pages and highlight the changes in numbers. I.e.: month 1 income +/-, Month 2 income +/-, Month 3 income +/-, etc. Determine how much each item changes and why.
- Have your bookkeeper make a report for you where you simplify the account names so they make sense to you.
- When you’re comfortable with those items and that regrouped format, walk through the basic ratios to develop an understanding of how they are collected and what they tell you!