Balance Sheets are More Important than Your P&L
Originally published: 05.01.19 by Ruth King
Every month you look at your profit and loss statement. You’ve never thought about looking at your balance sheet because you’re most concerned about profit and loss. You discover that your balance sheet tells you a lot more than you think it does.
Profit and loss statements only show profit or loss for a specific time period, usually a month or a year. Then, it starts again. In last month’s column I wrote about what to do in slower, usually less profitable months.
Most contractors celebrate when spring comes and business picks up. The bad months and bad P≈Ls are over! They look forward to new, positive bottom lines on their profit and loss statements.
Balance sheets show continuous profitability. Balance sheets track profits and losses from the time the business started (or was bought) until the day it was sold. How? Through the values shown in the retained earnings segment of the balance sheet.
If a company’s retained earnings are negative, then the business has been unprofitable year after year. Or, in a few cases, the company bought out a partner’s share of the business. This event caused retained earnings to be negative.
Negative retained earnings mean that if an owner wanted to sell his business, he would have to dig into his pockets to pay off the company’s liabilities since there are not enough assets to cover the company’s liabilities.
Balance sheets warn owners of impending problems. They answer the questions:
- Is the company getting more or less profitable?
- Is there enough money coming in the door to pay upcoming bills?
- Is it getting easier or harder to pay my bills?
- Is the company heading for a collection problem?
- Is the company purchasing too much inventory?
The company profit and loss statement cannot answer these questions. All it can tell is whether a month, a quarter, or a year had more revenue than expenses.
Changes in retained earnings answer question No. 1 above. If retained earnings are increasing, profitability is increasing. Another way to answer this question is to look at the current ratio (current assets divided by current liabilities).
Increasing current ratio generally means increasing profitability except in months with assets purchased for cash, large tax payments, or other unusual cash inflows or outgoes.
If the current ratio is less than one, then there is not enough cash to pay the company’s bills (question No. 2). This means, on a month-to-month basis, current liabilities or those bills which have to be paid within a year, are greater than current assets.
If your company is in this situation, the only ways out are continuous profitable sales or cash infusions in the business either through investments, loans, or sale of long-term assets.
To determine the answer to question No. 3, again look at the current ratio. If the company’s current ratio is increasing, in most cases, it should be easier to pay the bills. The only time it might not be easier is the answer to question No. 4 — the company is headed for a cash flow problem due to collections.
Here’s an example when this occurred: Many years ago, a contractor had more than a million dollars in receivables but didn’t have the cash to pay the fuel bill for his trucks. His outstanding receivables averaged more than 75 days old.
No one was paying attention to collecting money for work done. This was his wake-up call and he never had a receivable problem again since someone was calling on the 31st day when payments were not received per the terms of the work.
Receivable days and inventory days tell whether the company is heading for problems in these two areas. Receivable days are, on average, the number of days from the day the invoice was sent to the day the money was received. Inventory days are, on average, the number of days from the day a part was bought to the day it was used.
If a company is COD, receivable days are very small. However, a five day increase in receivable days is significant. That means that it is taking a week longer to get paid. Find out why.
Likewise, a five day increase in inventory days is also significant. Why does the company have an extra week’s worth of inventory on hand? The answer might be because of a seasonal stocking order. If this isn’t the case, find out why more materials were purchased than normally used.