How to read the balance sheet
The reality is that at least half of the items on the balance sheet are really only there for accountants, and don't matter much in the real world. Testament to this fact is that things like tangible assets, goodwill, shareholder’s funds and net asset value are often only calculated once per year, and typically many months after the year end has closed. If it was important, you'd want to see it at least quarterly and probably monthly.
But there are a handful of numbers which are really useful when running a small business or analysing company books.
The ones to watch are the items most closely connected to cash (and indeed cash itself).
The first group to keep track of is working capital, namely trade debtors (the amount owed to the company by clients), trade creditors (the amount owed by the company to suppliers) and stock.
This is because if your trade debtor value is going through the roof, all of the hard earned cash that would have been generated by the business, is absorbed because you are effectively financing the operations of your clients.
Equally, if the company bookkeeper suddenly has a burst of activity and pays all of your contractors in one go, the decrease in trade creditors will cause a good deal of cash to be consumed.
Once cash has been properly considered, the other important part of the balance sheet for business owners is the company's debt position and in particular the value and status of any loans provided to the business.
On the balance sheet, a company’s debt is split between current creditors (for debts due within 12 months) and long term creditors. So that means if a company has a £2m loan it is repaying over 5 years, £400k will be in current creditors and the balance will be in long term creditors.
But the problem is that the current creditor figure also includes non-financing debt – things like taxation (i.e. corporation, VAT or PAYE due to HMRC) and trade creditors. So you need to have a good look through the notes to the accounts to separate these out.
Many healthy companies will run a relatively large current creditor balance, because there is no need to pay HMRC or suppliers before you need to. So here are a couple of quick checks that you can do to see if these components of debt look OK:
- Trade creditors: take the number in the accounts and divide it by the sum of expenses excluding property and employees, then multiply by 365. This will give you an idea of the time it is taking the company to pay invoices. If it is around 30 days, then that’s pretty typical.
- Taxation creditors: add up the latest corporation tax bill (from the P+L), then calculate the typical outstanding PAYE bill by adding in 45% of the annual employee costs divided by 12. You can also try to make an estimate of the average VAT bill, which can be done roughly by calculating the annual revenue minus the sum of expenses (excluding property and employees) multiplied by 20% divided by 4. If when you add all of this up, it ties broadly to the number in the balance sheet, that’s about what you would expect for a company operating normally.
- Bank loans: once you have added up the bank debt in both current and long term debt, you need to compare this to the EBITDA. There was a time when banks would lend 5 – 6x EBITDA, but small business lending in the current climate tends not to exceed 2.25x EBITDA. Any more and it may well be the case that EBITDA is below the level anticipated when the loan was taken out.