Balance sheets are key to business health but remain poorly understood by most business managers

October 6, 2011 – RSM Bird Cameron, one of the largest mid-tier accounting firms in Australia, says management of balance sheets is one of the keys to business health but remains poorly understood by many business managers.

Looking at the balance sheet as well as the profit and loss (P&L) statement is vital to understanding the complete financial state of the business.

While there is no doubt businesses need to be profitable, they also need to sustain growth and have available resources to be reactive to customers and the market. The first step to improving cash flow management is to understand the dynamics of the balance sheet back to front.

Andrew Graham, national head of business solutions, said, “While most businesses understand and actively manage their P&L statements, the same can’t be said for managing the balance sheet. The error many people make is to focus on the P&L to the exclusion of all else, which can be a potentially fatal mistake as healthy profits can mask a cash flow crisis.

“In part this is because a traditional financial format of the balance sheet, which looks at the net financial position of the business, is not user friendly in terms of understanding what is going on in the business.

“Used in the right way, the balance sheet can be a valuable financial tool in showing the businesses net worth, the liquidity of the business, and liabilities.”

RSM Bird Cameron is suggesting businesses consider a shift away from the financial format to an analysis format to provide real insight into the business, and improve cash flow.

Analysis format works on the assumption that operations equal funding. It involves only looking at the assets in the business used to generate profit, which are fixed assets and working capital. It also considers the relationship of debt to equity in funding business growth.

Graham said, “Any change in the inputs required to operate the business will directly impact on the funding side of the equation. For example if debtor day blows out, the resultant cash shortfall will need to be funded by either an increase in debt or equity from owners or a combination of both.

“The premise of the analysis format is to make the invisible visible by highlighting the relationship between the operations of a business and how those operations are funded. Essentially it is about understanding the free cash generated by a business in order to repay borrowings and or increase dividends to owners, and is an absolute measure.”

Only with a comprehensive balance sheet is it possible to construct a useful cash flow budget. As a cash flow budget is only a “best guess” of a business’s cash inflows and outflows over a period of time, business owners should update and review the cash flow budget on a regular basis using conservative revenue and expense estimates. This will help provide an early warning system for potential cash shortages, and help build the business’s credit track record.

Graham said, “It is without question that a failing business will have cash flow difficulties, but business managers also need to be aware that a rapidly growing business is just as likely to have cash flow issues, and needs to keep in mind the implications growth will have on cash flow when expanding.

“Often it is during periods of rapid growth that businesses will either collapse or thrive.”

RSM Bird Cameron offers the following tips on improving cash flow:

1. Set credit terms carefully. The need to extend credit to customers is a fact of life for
   most businesses, but it is important to set clear limits. Carefully research the standard credit
   period for your industry and make an honest assessment about the consequences of shortening credit terms. Reducing the payment period from 90 to 60 days might lose you one customer, but if the others will pay more quickly it could be worth it.
   
2. Make debtors pay quickly. It is vital to master the art of debtor management. One suggestion is to ensure debtors know how much time they have by sending payment notices on different coloured paper – with 30 days to go, send a blue notice, 15 days an orange notice and bright red when payment is required immediately. Talk constantly with major debtors as payment deadlines approach. A small discount for early payment can also provide an effective incentive.
   
3. Pay creditors slowly. Take advantage of credit terms and prioritise costs according to the severity of the consequences for not paying. Wages, taxes and direct debits are at the top of the list, key suppliers second and everyone else last.
   
4. Smooth out the lumps. Know when lean cash flow patches are coming and plan accordingly. It is invariably more difficult to get debtors to pay at business activity statement (BAS) time and over Christmas, so make sure you have a bit of leeway in your cash accounts to pay wages and other inflexible expenses during these periods.
   
5. Use finance products effectively. Overdrafts, premium funding, lease facilities and cash flow funding products can all be excellent tools to help match a business’s cash supply with planned outlays.
   
6. Do not incur penalties. Some creditors may impose penalties for late lodgements or payments in some circumstances. Paying these debts first will save money and stress.
   
7. Keep your hands out of the till. Discipline yourself to make cash drawings only in line with conservative cash flow forecasts. Cash drawings are effectively just another expense for your business and should be acknowledged as such.