The importance of having a strong balance sheet, and how it can affect your business

Businesses with strong balance sheets are more inclined to survive economic downturns and remain in a better position to succeed when the going gets good again.

A strong balance sheet involves more than simply having more assets than liabilities, your balance sheet will need to be structured to support your business goals and in turn maximize financial performance. This can be achieved by maintaining intelligent working capital, positive cash flow, a balanced capital structure and income generating assets.

Intelligent working capital

A strong balance sheet will utilize an optimal level of working capital (current assets less current liabilities) to fund the business core operations, with the end goal of deriving revenue and subsequently profit. It is important that you can identify what the optimal level is for your business. The aim here is to strike a balance between liquidity and profitability, which are often conflicting strategies. Having an excessive amount of funds tied up in stock will strangle your cash flow and reduce your ability to meet financial obligations as they fall due. On the other hand, having too much cash sitting in the bank could be coming at a massive opportunity cost to the business and could be better utilized by investing in higher income - generating assets or paying off debts.

Positive cash flow

Although this is a part of working capital, it is so important to a business that it requires its own section. Cash is one of the most important signs of a strong balance sheet, as your business will not be able to breathe without cash flow. All businesses need cash to achieve their short -term goals - to pay employees, trade payables and a host of other expenses. It’s therefore vitally important to manage cash flow through forecasting, budgeting and the use of variance analysis.

Balanced capital structure

A strong balance sheet will employ a balanced mix of debt and equity funding to maximize the return on capital employed. Debt is usually a cheaper source of financing as interest is deductible and shareholders often require a higher return on their investment. However, taking on debt always poses some risk - it can be rewarding when times are good but dangerous when there is a downturn. Because of this risk, managing banking covenants becomes imperative. Equity financing can be more expensive but is considered less risky as there is no obligation to repay your shareholders periodically. Entities with strong balance sheets retain enough earnings to fund growth and achieve business goals while distributing excess funds to beneficiaries. Often strong balance sheets are the result of borrowing debt at a good time, (for example when interest rates are very low).

Income-generating capital assets

A business requires suitable capital assets to generate revenue, with some entities more capital intensive than others. Management should invest in assets which will assist the business in achieving its financial goals. These capital assets must be reviewed regularly, and if they are not performing then move them on and invest in those which are.

Strengthening your balance sheet

There are numerous reasons why a business might not have a strong balance sheet - poor financial performance, taking on unserviceable debt, stripping too much money out of the business... the list goes on. Taking steps to strengthen and maintain a strong balance sheet will help your business thrive during even through the toughest of times. It also decreases the risk of failure. Growing business can be expensive, but a strong balance sheet will serve as a foundation from which you can launch into new products and markets. Not to mention - bankers love nothing more than seeing a solid balance sheet with healthy cash reserves and a balanced capital structure when assessing loan applications.

Overall, a strong balance sheet will make you more agile and give you options to shape a more profitable future.