Q: My bookkeeper does a good job of inputting data. That said, he doesn’t know how to help me with the numbers. When I was poking around in our financial system I printed a balance sheet. I know it’s important; how can I use it as a tool?

A: There are three financial statements most commonly used in business. The Income Statement, (commonly called the Profit and Loss or P&L) the statement of Cash Flows and the Balance Sheet. The most relied upon report is the P&L; the least analyzed is the Statement of Cash Flows; and the most mysterious and ignored is the balance sheet. All these statements interplay with one another, and all are important.

The basis for accuracy for all financial information is the balance sheet. It’s broken down into three areas: Assets (what you own), Liabilities (who you owe) and Equity (what’s left in the business after everything is purchased, depreciated, paid and saved). Assets equal Liabilities plus Equity, as of a certain date, usually the end of a period. Every account on the balance sheets needs to be reconciled and accurate at the close of each period. If items are left unreconciled, you may see sudden adjustment to the P&L in future periods. Check with your accounting professionals to ensure this important work is being performed at each period close. Once you know your accounts are reconciled. Move to analyzing the statement. Simple balance sheets are broken down into simple categories. Assets consist of current assets, fixed assets and other assets. Liabilities consist of current liabilities and long-term liabilities. The equity section depends on the company structure and is often money contributed and drawn by ownership, current year net income and retained earnings. Use the information on the balance sheet to assess the financial health of the business.

The first ratio to assess is the number of days’ sales of cash on hand [cash on hand/average daily sales]. Days’ -sales-on-hand should be greater than 14 days or two weeks. To prove this out, payroll typically runs between 30 percent and 40 percent of sales. If payroll is paid every two weeks, 60 percent and 80 percent of one week’s sales will be used. There are still other bills to pay with the rest of the cash on hand. Dipping below two weeks of sales in free cash flow will cause timing issues. The perfect storm is right around the corner of payroll, vendor payments, rent, debt and tax payments all colliding around the beginning of the month. The perfect storm will consume a fair share of two week’s worth of sales. If you have less than 14 days of sales in cash on hand, it’s time to build cash and reduce spending.

Secondly, determine the current ration [current assets/current liabilities]. This signifies the ability of the business to meet its obligations in the short term. Current assets can be converted to cash within one year and current liabilities need to be paid within one year. If this ratio is less than 1:1, vendors and employees are contributing more to the business than the business itself, or too much cash is being taken out. If that ratio slips to 0.5:1 the business is in need of a cash infusion, and unless the ration is reversed, the business will struggle from payroll to payroll. Poor cash positions drain the resources of the organization away from focusing on what’s most important.

Thirdly, compute the days’ sales of inventory [food inventory / average food cost of goods sold]. Inventory is cash converted into items held on the shelf. Too much inventory can drain cash. Keep food inventories at seven days or less and beverage at 35 days or less (substitute beverage in the equation above). Too low means too little storage and too many deliveries driving your cost structure up. Too high means product is not being converted into cash to pay bills.

Finally, evaluate equity [total assets – total liabilities]. Equity shows how much residual asset value you have left in the business and should be a positive number. Negative numbers indicate more liabilities than assets, signaling that you are living on your vendors and your employees – a dangerous predicament.

The balance sheet is a useful analytical tool. Ensure these ratios are positive, and you’ll be on your way to a better night’s sleep.

For more information on improving profitability and driving performance, contact AMP Services at [email protected]. Rick Braa is the co-founder of AMP Services, an accounting and consulting firm specializing in helping companies grow profitability.