Wealth Rule 1: Pay Attention to Your Balance Sheet
Originally published: 02.01.20 by Ruth King
Last year I wrote about the rules of Profit. This year I will write about the rules of Wealth. All rules are in my upcoming book, “Profit or Wealth?: Simple Rules for Sustainable Business Growth,” which will be released this October.
Unfortunately, most contractors don’t pay attention to their balance sheet. They live only by what their P&L is telling them. A contractor can go out of business just paying attention to his P&L. You’ll discover why over the next few months.
Your balance sheet is where you build wealth. This financial document tels you true profitability. The longer you are profitable, the more opportunity you have to build wealth. This doesn’t mean that you will build wealth. You must take the steps to actually build it.
Your balance sheet shows you how healthy your business is. It started the day that your company started or the day you bought it. It ends the day you close the doors or sell it.
Your balance sheet gives you warning signs. It tells you:
- If profitability (i.e. long-term profits) is increasing
- If you can pay your bills
- If debt levels are getting too high
- If inventory levels are getting too high
- If you’re heading toward a collection problem.
Your balance sheet must be accurate. Here are five common balance sheet mistakes.
You cannot have negative cash on your balance sheet. This means there is a negative cash balance in your checking account.
Often when I see a negative cash balance, the company’s bookkeeper has written the checks for all of the bills due in a month. They are sitting in the bookkeeper’s drawer until enough cash comes in to pay those bills.
At the end of the month, if enough cash has not come in to cover the bills, the balance sheet shows a negative cash balance. Even worse, it shows a smaller amount of accounts payable due. You think you owe less than you actually do.
Your bookkeeper should only write checks when there is cash to cover those checks. Otherwise, you’re fooling yourself about the health of your business.
Track Your Inventory
Or, no inventory at all. There is less than a one in one million chance that your inventory is exactly $20,000 or $3,500. Or, the inventory value is the same every month. When I see this, I know that inventory is not being properly tracked and that material cost is usually not accurate either.
Inventory is a bet (See Profit Rule No. 9, HVACR Business Sept. 2019, pg. 17). You’ve bet your hard-earned dollars that when you buy a part or piece of equipment that you can sell it at a later date. Make sure you make good bets.
Negative Loan Balance
A negative loan balance means that the bank owes your company money for a loan. The company owes the bank the loan amount; the bank doesn’t owe the company. Generally, when I see this, it is close to the end of the loan payments.
As the bookkeeper is making the monthly payments, the bookkeeper has entered the entire monthly loan payment as a decrease of the loan liability.
This is incorrect. Part of the monthly loan payment is principal reduction of the loan amount and part is interest the bank is charging your company for the privilege of having the loan. The interest is an expense to your business and is shown on your profit and loss statement. The loan principal reduction is shown on your company’s balance sheet.
Like negative loan balances, it is unlikely that the Internal Revenue Service or your state revenue department owes your company money. If so, the bookkeeper has made an error in the payment calculations.
Net Income Doesn’t Match
Net income on your P&L must match retained earnings. The net income from the profit and loss statement is transferred to the balance sheet. The amounts shown must exactly match!
If they don’t, then make sure that both the profit and loss statement and balance sheet show the same date (i.e. both are reported as of January 31st) Then make sure both are shown on an accrual basis. If the year to date net profit and year’s retained earnings aren’t consistent, then someone is probably embezzling from your company.
Reports Don’t Match
Accounts receivable and accounts payable on the balance sheet should match the accounts receivable and accounts payable balances shown on the aging reports.
Print out report showing the list of accounts receivable and accounts payable each month. The total balance on the accounts receivable and accounts payable aging reports should match the values printed on the balance sheet.
If they don’t match, someone has usually put entries in through journal entries rather than through your accounts receivable and accounts payable systems.
Checking for these five errors takes less than five minutes. Correcting them may take longer.