How to Get More Business Value by Understanding Finance
Posted by Christine
13 November 2023
The balance sheet is a snapshot at a point in time showing the assets and liabilities and the net value of your business. It shows you what value the shareholders’ funds are and therefore what’s the value of your business is in very simple terms. Understanding your balance sheet with boost your business success.
It’s important to understand your balance sheet because it shows you how to recognise the value in your business and what your assets and your liabilities are.
“The two most important things in any company do not appear on its balance sheet – its reputation and its people.” – Henry Ford
Why is it called a balance sheet?
The balance sheet is made up of amounts of money that are owed to the business and amounts of money that are owed by the business (plus a record of the cash that you’re currently holding).
Assets fall into two main categories – current assets and non-current assets, including:
Fixed assets are non-current assets because they cannot be easily or routinely converted into cash.
Fixed assets are owned by the company, such as computer equipment and machinery that’s used to produce products. It will also include the tables and the chairs in the office, and possibly telecoms equipment. Fixed assets will be items that you have purchased for the business that have a long (over one year) economic value to the business.
For example, you buy a piece of machinery that produces your widgets, and you pay £100,000 for this equipment.
The machine works at producing hundreds of thousands of widgets over, let’s say, the next five years (often its much longer!) It would be a misrepresentation of your profits to show a reduction of £100,000 in one year, then have a huge rise in the following year profits because you haven’t spent money on equipment. A more accurate reflection of profitability would be to take account of the economic value that is being provided by that piece of equipment across all the years it is in use. This is called Depreciation.
Depreciation is the allocation of the economic value that is used in a financial period, of the assets that the business has made use of. Depreciation is applied to both the Profit and Loss Statement as utilisation of the economic value of the asset AND to the Balance Sheet as a reduction of the on-going value of the asset.
Going back to our widget making machine. We know it’s going to cost us £100,000 and we know that it’s going to produce widgets over five years, or more so we apply the right amount of depreciation to the profit and loss statement, i.e. 20% or one-fifth of the £100,000 is deducted from our profits as a non-cash overhead.
In the example company, a machine was purchased at the cost of £7,500, and it has an economic lifespan of 10 years:
Example
Cost of Acquisition: £7,500
Economic life: 10 years
Depreciation: £7,500 = £750 p.a.
10 (£62.50 p.m.)
Now this means there is a distinct difference between cash and profit because our profit wouldn’t be hit by the full £7,500 purchase but cash most definitely would.
Cash would not be reduced by depreciation because it’s a nominal sum but our profit would. Fixed assets are recorded in the Balance Sheet at their original cost and are slowly diminished in value over the period of their economic viability by the application of depreciation.
Current assets are any assets that can be and will be converted easily into cash and includes stock, work in progress, debtors and cash.
DEBTORS
Debtors are customers who you have sent an invoice to, but the invoice is still due to be paid. Your customer owes you a debt which is why they’re called debtors. Sometimes debtors don’t or resist paying!
I strongly recommend you have a mechanism for consistently following up invoices and requesting payment to ensure that your customers pay on a timely basis. For some customers’ it is common practice to only pay when asked, so it’s important to ask for payment at the right time.
You should also have a credit policy to make sure that you don’t sell to customers who have no capability of paying. A credit policy is a routine that your business should run to make appropriate credit checks on customers to ensure they have the capacity to pay for the products and services they buy from you. Asking other suppliers for references is part of most credit check processes.
Every now and again a business will experience something called a bad debt. This is where the debtor has no capacity to pay even when you chase them. Once the debt looks unlikely to be collected, you cannot show it as an asset in your balance sheet, and you must write it off.
If you experience difficulties in getting customers to pay you, there are some easily deployable ways to get paid shown below.
GETTING PAID
The secret to not experiencing late payment is in the systematic and consistent application of credit control. At its most basic, your system should involve maintaining good relationships with your customers.
Do not be afraid to call your customers up and ask for payment if it is due. Delays in payments may occur due to oversight, so a friendly reminder is OK. Being proactive and letting customers know you are expecting their payments a few days in advance is a good habit to have, and one your customers will quickly get used to.
See an example sequence that follows:
STEP 1 – Reminder: Due date – 5 days
The attached invoice is due for payment in 5 days. If there are any issues that are currently blocking this payment, please let us know. Kindly forward payment to:
Bank Account:
Bank sort code:
Payee:
STEP 2 – 1st Chase: Due date + 7 days
The above invoice was due to be received on dd-mm-yyyy. If there is a reason for non-payment please contact EMAIL ADDRESS. We kindly request you forward payment to:
Bank Account:
Bank sort code:
Payee:
STEP 3 – 2nd Chase: Due date + 14 days
**Liaise with project / sales lead if necessary to find out if there is a reason for non-payment > Action required > Feedback to finance department:
The above invoice is considerably overdue. As we have not been made aware of any reason for non-payment kindly submit your payment to the details below and inform me of an expected payment date:
Bank Account:
Bank sort code:
Payee:
STEP 4 – 3nd Chase: Due date + 28 days
**Liaise with project / sales lead to make sure no relationship management is needed > Email contact:
The above invoice is now significantly overdue. Interest shall be charged at the Bank of England base rate plus x% (whatever is in your terms and conditions) as per our terms and conditions. To avoid legal debt recovery action please pay soonest.
Bank Account:
Bank sort code:
Payee:
Working capital is effectively the oil that keeps the engine of a business working. If you don’t have any oil, the engine will seize. If a business cannot meet its obligations when they fall due, the business will cease to be a going concern. A business must continue to be a going concern. Otherwise it is unable to trade and must go into liquidation.
Working capital is the capital being used to run the day to day operations of the business. It is the current assets (debtors, stock) and the current liabilities (creditors and short-term debt) and cash or overdrafts.
Stock and Work in Progress (WIP)
A business will buy products from suppliers and, in the case of manufacturing, convert them into products that are sold as finished goods. In the case of retail businesses, the products are purchased from wholesalers and resold. The products form stock which ties up cash in the business while waiting to be sold.
The time between buying components, converting to finished good and selling the product is your working capital cycle. If you are selling services the working capital cycle is the time between providing the services and getting paid – usually you will have paid staff wages and expenses as part of the service delivery.
Understanding what you’re working capital cycle is will help you understand whether you need funding if you make plans to grow the business.
Example (Very Simple)
Therefore, cash is tied up in your stock for six weeks (from 30th May through to 15th July).
Working Capital Ratios
Stock turnover
This measures the number of days it takes for a business to sell its stock (on average). It is measured using the average stock holding and divide it by the cost of sales, all multiplied by 365 days:
Average stock £ x 365 divided by Cost of Sales £
You can find the average stock by taking the average of the opening and closing stock in your annual accounts.
“Every decision you make in business has a financial consequence.”
Barbara Vrancik
Debtor turnover
This measures the average number of days it takes to collect money from customers:
Average trade debtors £ x 365 divided by Sales £
You can find the average trade debtors by taking the average of the opening and closing debtors in your annual accounts.
Creditor turnover
This measures the average number of days it takes to pay money to suppliers:
Average trade creditors £ x 365 divided by Purchases £
You can find the average trade creditors by taking the average of the opening and closing creditors in your annual accounts.
Purchases are not a number that are recorded in your accounts, and can be calculated as follows:
Opening stock (in the balance sheet)
Plus Purchases (unknown)
Less Closing stock (in the balance sheet)
= Cost of Sales (in the P&L)
Therefore,
Purchases = Cost of Sales + Closing Stock – Opening Stock
“Capital isn’t scarce, vision is.”
Sam Walton
Some useful numbers for understanding your business resilience are liquidity ration and the Acid Test.
Liquidity Ratio
Overtrading is when a business is trading while being unable to meet their current liabilities or current obligations as they fall due. Many business owners do not understand when they are doing so and the business goes bust as they run out of cash.
The liquidity ration can be used to see if the business is at risk of overtrading. This ratio measures the ability of the business to meet its obligations as they fall due.
Current Assets divided by Current Liabilities = liquidity ratio
A good liquidity ratio depends on the type of business you have but as a benchmark, two or more is good for manufacturing, and one is reasonable for a service-based business.
Current assets = Stock £4,000, Debtors £1,000 and Cash £500 = £5,500
Current liabilities = Creditors £3,000
Liquidity ratio = £5,500 / £3000 = 1.8333
Acid Test
To get a better feel for how the business is doing, in terms of its cash and its liquidity, take the liquidity ratio and remove the stock value.
The reason why stock is deducted is because stock is often not easily converted into cash, it relies entirely on sales activity, and this cannot always be effectively predicted. Having a large amount of stock, and not being able to convert it into cash quickly will impact the company’s liquidity and its ability to meet its obligations. This is one of the critical factors in businesses failing.
This gives you a better idea of how capable the company is of meeting its obligations as they fall due and a better view of the immediate liquidity or the ability of a company to satisfy its cash demands.
Current Assets Less Stock divided by Current Liabilities = Acid Test
In the example numbers for ABC Company:
Current assets = Debtors £1,000 and Cash £500 = £1,500
Current liabilities = Creditors £3,000
Acid test = £1,500 / £3000 = 0.5
Your liabilities are monies owed by the company. These invariably fall into one of three categories:
They are also categorised as Current Liabilities or Long-Term Liabilities.
Current liabilities are anything that can be expected to be paid in cash within the next 12 months, and this includes short terms loans. Anything payable within the next 12 months is a current liability.
Long-term liabilities will often be loans over a period of more than 12 months. Sometimes your long-term liabilities do include longer-term tax liabilities.
Long-term generally refers to anything not due to be paid within the next 12 months.
CREDITORS
When a company owes money to its suppliers, these are called creditors, suppliers have given the company CREDIT (i.e. time to pay). It is common for suppliers who you have built a good relationship with will give you 30 days’ credit (in some cases longer). You have received the goods which will be recorded in the balance sheet as stock and the invoice (which is simply a demand to pay) needs to be recorded somewhere, and it’s recorded in Creditors as current liabilities. So, a creditor is someone that we have made a purchase from who is still owed the money and hasn’t yet been paid.
Creditors are the opposite of Debtors
TAXES
Taxes are monies that are due to be paid to HMRC for VAT, payroll taxes (PAYE and NIC) and for corporation tax. VAT may be payable quarterly and Corporation Tax is usually not payable for several months after the accounts are prepared, but both are important to be paid on time as HMRC have significant powers to force payment and will add punitive interest as well as fines for late payments.
Knowing what you owe to HMRC and when it is due to be paid should be recorded in your Cash Flow forecast as well as in your Balance Sheet!
LOANS
I have seen many business owners resist borrowing money for their businesses. Pre-2008 the banks were literally throwing money at businesses with cheap, easily available credit being touted to just about everyone. While those days are over, there are still plenty of funds available to companies who are growing and investing in their future. It’s just a bit more of a challenge to get the funds released!
With my very first business, I was offered (and took) an open line of credit, up to £6m to start with, for acquiring other businesses to allow my company to grow quickly. For someone who had never had anything more than a car loan of a few thousand pounds before, this was a daunting prospect! I quickly got used to it because of the difference it made to the speed with which that business could then grow.
GETTING FUNDING
There has been plenty of press coverage on how the lack of adequate funding is causing problems for small and medium-sized businesses. As many as 60% of all loan applications are turned down – but don’t let rejection on first application put you off. There are many more funding sources than the traditional big banks, many of which are small business friendly.
Most business owners take the first rejection of an application for a business loan as absolute and don’t make any further applications to anywhere else.
So, if getting access to credit is more difficult in the post-crash era, why borrow money?
One of the benefits of borrowing money is that you can grow the business without using any of your own cash. By not having to wait till you have the level of funding you will need gives you a lot more flexibility and improves the speed in which to grow your business – especially if you are investing in new premises, more equipment or even expanding your workforce.
Repayments of the capital are made from future sales – the cash allows you to get more sales volumes and accelerates the cash you receive, as long as you have the right margins!
The additional benefit is that the interest associated with debt is tax deductible, therefore the interest reduces the taxable profit of the company and less tax is paid. One way of looking at this is it reduces the impact of your interest payments by the tax benefit received.
EXAMPLE (Profit and Loss impact)
Loans No loans
Operating profit £ 85,000 £85,000
Less: interest £ 10,000 £ 0
Less: tax due £ 15,000 £17,000
The Balance Sheet also shows the amount of money that, if the company was to liquidate all the assets and liabilities at the current values, the shareholders could expect to receive.
Shareholder’s funds are simply a sum of the assets, less the liabilities. Or if you want to look at it a different way, the shareholder’s funds plus the liabilities equals the total assets. And typically, your balance sheet will show the assets, less the liabilities, less the shareholder’s funds, and that should come back to zero. This is why it’s called the balance sheet.
Shareholder’s funds are simply the amount of money that would be returned to the shareholders if the company ceased to exist. In simple terms, if the business was to close today and be liquidated and all the balances converted into cash then this would be the amounts of money that the shareholders would walk away with. It’s shown on the balance sheet as a liability because it is the amount of money that the business owes to the shareholders.
NOTE: A word of caution. The Shareholders Funds are NOT the sale value of the company. Additionally, if the company were to close, even voluntarily, it may not recover the full value of its assets in cash.
HOW A COMPANY IS FUNDED
Every company starts off with raising some cash, regardless of the value, either from the founders or by going and raising it from investors. I have started businesses with £100 and a laptop using Costa as my office, equally I have raised nearly £1m of shareholder investment and borrowed heavily from the banks to start another more complicated but instantly profitable company.
When trading as a sole trader, then you and your business are linked and there is no real separation of your business identity and your personal identity.
By contrast, a Limited company is a separate legal entity, (think of it as a separate individual), and it must have at least one shareholder, and at least one director. A Limited Company can enter into contracts, borrow money and get investment from 3rd parties in its own name!
A new company uses the start-up cash to buy the assets that it needs to fund trade and generate profit. This profit is then turned into more cash, although profit is not the same as cash.
When a company is generating cash from its profitable activities, it can either choose to reinvest the cash in more stock or other assets to generate greater profits, or it can return the cash to the shareholders. When a company is growing, it often needs more cash than it’s generating.
Two sources of cash can be available to a company:
or
Borrowings and Debt
When money is borrowed, there will be interest attached to the repayments. And the interest levels will be a direct reflection of the risk that the lender feels they are taking.
Secured Loans are borrowings supported by a repayment promise from the shareholders, or against assets within the business. With the money secured against something that has a cash value, it’s likely to attract a lower level of interest. The lender is mitigating their risks.
Unsecured loans are lent in good faith based on the business performance historically; then it’s usual to attract a higher level of interest. The lender is taking a bigger risk and expects to receive a higher rate of interest.
What’s critical to understand when borrowing money, is:
“A bank is a place that will lend you money if you can prove you don’t need it.”
Bob Hope
What is EBITDA?
You may have heard or seen the phrase EBITDA, E-B-I-T-D-A. EBITDA is often used as a base value that can be applied to a business when looking sell. EBITDA times are “multiple” which depends on your industry and a number of other factors. It’s a very blunt instrument to measure the economic value of your business. It is not, by any means the only method of valuing your business. (There are whole other books written on this subject).
Earnings Before Interest, Tax, Depreciation & Amortization.
Earnings are your net profit before you’ve charged the cost of borrowing. Depreciation and amortization are simply the spreading of the economic value of a larger purchase of fixed assets. Depreciation being the spreading of the cost of tangible fixed assets, such as machinery and cars.
Amortization is the spreading of the economic value of intangible assets, for example, goodwill, intellectual property or patents, for example. There are specific accounting rules for intangible assets which you should discuss with your accountant.
“You only live once, but if you do it right, once is enough.”
Mae West
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