Track your assets: financial formulas to keep your business in the black - includes related article on tracking equity earnings - part 2 - Small-Business Financial Series: Money Managing - Industry Trend or Event

Home Office Computing, Sept, 1997 by Jeannie Manelker

Happiness may be a positive cash flow and a growing bottom line, but that's not the sole measures of success. Obviously, if you draw a salary from your company, you have additional incentive to want to run your business effectively. Yet to really examine your venture objectively, you have to remove yourself from the picture and slice your data a little bit differently.

To accomplish this, envision your firm as a factory being built and your profit as the product it manufactures. Naturally, your building should be in tip-top shape. If its foundation is weak and the walls are crumbling, then your product is bound to suffer. So how do you survey the stability and efficiency of your "factory"?

One of the best measuring sticks is your balance sheet -- an underused financial management tool that tracks your return on investment and shows your level of outstanding debt. In this second installment of our three-part financial series, we provide a balance sheet blueprint. Then we help you zero in on your weak by using financial ratios.

Why ratios? "Sometimes you get a vague sense that something is financially wrong, that cash flow is tight," says Barbara Rowe, Ph.D., an extension specialist at Purdue University and former small-business owner. "And ratios help you pinpoint exactly where the trouble is. You can see if your pricing is off or if you're overinvesting in fixed assets." And if you already have the financial infrastructure -- accounting software -- in place, crunching more numbers and managing your business assets become a snap. For information on profit-and-loss and cash flow statements, see "Recordkeeping: Get Your Books in Order " August, page 64.)

Lay Your Foundation The balance sheet -- which lists both your resources (assets) and claims against those resources (liabilities) -- will help you see how sound our financial structure is. It tells you where your capital comes from and where it's destined to go at certain periods in time, such as the end of a quarter or year. By studying this blueprint carefully (see "How Much Is My Equity Earning?"), you'll discover the actual amount of your investment, whether you have enough money to meet your short-term obligations, and how your current level of debt affects your solvency.

So what's listed under assets? Anything of economic value to your business, such as cash, accounts receivable, inventory, and property. To compile a balance sheet, record your current assets first -- that is, those that are most liquid. This includes cash, anything that can quickly be converted to cash, or items that you may turn into cash within a year -- accounts receivable, for example. Next, list fixed assets, or items that take time to convert into cash, such as property and other intangibles.

To offset your resources, record your liabilities in the same manner, with the most current, such as accounts payable and short-term debt, listed first. Then include long-term debt -- mortgage loans or deferred income taxes. Finally, list owners' equity, the capital you and your investors have kicked in. This section of the balance sheet measures how much debt and equity is in your business. The point of this is to ensure that your assets and liabilities balance each other, hence the name balance sheet. (Note: Categorizing assets and liabilities can be complex. So even if you use software, you may want your accountant to look over your initial balance sheet.)

As you'll see, having a balance sheet lets you evaluate your company's ability to pay off debt. "People are too quick to borrow money without thinking of paying it back," says Brian C. Greenberg, a CPA in Marlton, New Jersey. "A high level of debt is quite risky: In a downturn, when business dries up, the debt is still there." But with a balance sheet in hand, you can see if you've overextended yourself and need to be better prepared to pay debts back.

Use Your Ruler Simply put, financial ratios let you measure and play with the numbers in your balance sheet and profit-and-loss statement so you can see their relationship to each other. Undoubtedly, you're familiar with your net profit margin (or profitability) ratio: By dividing net income by net revenues, you know what percentage of each revenue dollar you pocket. But there are other ratios that measure such strengths as:

Liquidity, the ability to pay your obligations as they come due and still fund your operations.

Efficiency, how well your company uses its assets.

Leverage, your ability to borrow funds to generate a greater return on your invested capital.

Like a savvy investor, you'll want to scrutinize your liquidity and leverage, because too much debt can erode your business over time or suddenly kill it. On the other hand, too little debt will constrict your growth.

Your most important tool to determine debt is the quick (or acid test) ratio, which is your most liquid assets divided by current liabilities (payments you must make over the next 12 months). "If you measure nothing else, this is critical," says Greenberg. "In most businesses that fail, the quick ratio is usually below 1:1." Use this ratio as a red flag: It could indicate a slowdown in collections or the overuse of a line of credit. To secure your firm's financial structure, you could step up collections or substitute long-term debt for short-term credit.