B is for Balance Sheet
I get it. You might not want to talk about your Balance Sheet. It's not incredibly exciting. And it's not what people typically want to talk to you about. They usually just want to talk about your Revenue. Maybe your margin. If they're really sophisticated, maybe they want to dissect your full P&L (not PNL). And that's great. And that makes sense. It's where you spend a significant amount of time. Reviewing performance. Identifying obstacles. And, celebrating successes. And it's not just the P&L (not PNL). You're reviewing detailed Sales Metrics every single day. And maybe, because you're spending so much time there, in Sales, that you're only giving the Balance Sheet a passing glance. Or, maybe you're skipping it altogether.
And, I get it. You're so busy. But, reviewing your organization's performance without digging into the Balance Sheet is like a college admissions officer only looking at an applicant's academic performance for the last nine weeks. Or the last semester. But, that's not enough - we need more. We need the full high school transcript. The cumulative grade point average. The life to date scorecard. And that, my friends, is the Balance Sheet.
At its most basic level, the Balance Sheet is a financial statement that presents an organization's financial position at a specific point in time. It shows your organization's Assets (think Cash, Accounts Receivable, Inventory). It shows your organization's Liabilities (think Debts, like Loans, Accounts Payable, and Pending Payroll). And it shows your organization's Equity (think Shares and Retained Earnings).
And it's called the "Balance Sheet", because...drumroll please...it B-A-L-A-N-C-E-S!!
Assets = Liabilities + Stockholders' Equity
I can hear you now. "Stop it right there." But wait, there's more. It's the Balance Sheet that we look to to determine the organization's overall health and wellness. From just one Balance Sheet review we can see so much. We can see if your Assets are sufficient to cover your financial obligations. And, we can see if you're highly levered (high multiple of debt compared to your equity). We can see how much Cash you float, by calculating your Conversion Cycle (how long it takes you to get paid by your customers + how much inventory you hold - how quickly you pay your obligations). And so many more incredible insights that can be gleaned from just one stand alone Balance Sheet.
But, if you really want to dig in, and you do - because this is your business. Your vision. And likely, your legacy. We should look at a trending Balance Sheet. A series of your organization's Balance Sheets at different points in time. Maybe year over year for a three to five year period. Or maybe month over month for a twelve month period. Or both. Because this really lets us "read the green", showing us how your organization's financial position has shifted - ebbing and flowing - over a period of time. Performing a trending fluctuation analysis (how did the balances change over time, and what drove those changes?) or an overall metric trending review can uncover a bevy of issues that are not easily detected by a mere glance at your Balance Sheet. And when we're doing it enough, we start to see the play before it even happens. And that. That's the real magic.
Still not a believer? True story below.
Let's say your Sales and Expenses look great. Sales are up. Expenses are down. And your P&L and Net Margin are strong. Optimal, even. Better than industry (and you know this because you regularly benchmark against your publicly traded competitors). But, Cash has been feeling tight lately. And you've had to borrow more than usual against your Line of Credit. You've been really busy, running the business and putting out the typical daily fires, so you've not yet noticed that the line is almost maxed out. And it's about to to impact Operations.
We pull a six month trending balance sheet, and get to work. And, there it is. While your Current Ratio (Current Assets/Current Liabilities) looks healthy, other metrics have been trending in the wrong direction for some time.
These have been declining...
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While these have been ballooning...
And now you're now floating quite a bit of cash. And, well, it looks like you might be in a bit of a pickle. But...your Sales. Your Margin. How did this happen?
Let's dig into the details:
Inventory: We see that we've been buying way more inventory than usual. In fact, your inventory balance is three times higher than average. It's almost like we're stockpiling.
Accounts Receivable: Our balances with two of our largest customers have grown exponentially. In fact, it doesn't look like we've received a payment from either customer in about four months.
So, we start with Supply Chain. Through conversations, we learn that our new Supervisor found a killer deal on some inventory. And if he bought more, he'd get an even better volume discount. So, he bought more. And more. And more. Because, these are items we frequently sell. And, we're getting a great deal. This gentleman knew about the P&L. That if he helped compress expenses it would bolster profitability. Ultimately increasing margin. Which is great. But, he's not privy to the cash management piece. Not thinking about the cost of capital and proper liquidity. And lack of appropriate internal controls and proper checks and balances allowed this practice to go undetected for months.
Next, we call our key Customers with large outstanding balances. Turns out, they'd both been sending checks. They value our relationship, and would never not honor their obligations. But, they've been sending their checks to the wrong lockbox. Four months ago, we'd transitioned from one bank to another. And we'd sent out numerous communications to all of our vendors. Great, detailed communications asking them to update our "remit to" address. But, one customer hadn't received the notices and the other did, but missed updating our "remit to" address while his AP Supervisor was on vacation - and the checks never made it to us.
Fortunately, after some digging, these issues were easily resolved. And to prevent this from persisting, we instituted appropriate internal controls within Supply Chain, monthly AR reviews with Revenue Cycle, and a robust monthly Balance Sheet review. All great things.
And we even established a 13 Week Rolling Cash Forecast. Because, every business needs one of those.
And, well, wait. You've got one of those, right?