Many business owners look at their profit and loss statement and determine if they’re profitable or not. How is revenue tracking against last month or last year? Any changes in gross or net profit margin? If I’m making money then everything must be ok. There is some validity to that way of thinking.
However, earlier this year, I attended a business summit where one of the guest speakers made the statement “your balance sheet is more important than your income statement” and then went on to explain why. Here are some of the reasons she gave:
- While the P&L reveals the ability of the business to generate a profit, it does not reveal the amounts of investment needed to support sales and profits.
- The balance sheet reveals the liquidity of the business. A balance sheet list assets from the most liquid (cash) at the top to the least liquid at the bottom (fixed and other assets). You’ve heard the expression “cash is king.” Liquidity is needed to fund payroll, handle operating expenses and provide owners’ distributions for taxes.
- Watching trends on the balance sheet (when paired with the income statement) helps you calculate changes in your key performance indicators over time. Am I collecting my accounts receivable faster or slower? How is my inventory turning? Without the balance sheet, you couldn’t monitor changes in these trends.
- Your balance sheet tells how much of your assets you own vs how much your creditors own. When you buy a house and put 10% down, your lender “owns” 90% of your house. Over time, you pay the loan down to the point where you have no debt and you own 100% of the house. Think of your business the same way. Financial leverage is using debt to finance your business with cash you don’t have.
The question is how much leverage is enough and how much is too much? Most borrowing for a business starts with a line of credit and is secured by accounts receivable. Most banks are willing to loan 75-80% of your accounts receivable as a maximum. That means they’re willing to give you $3-4 of debt for every $1 of equity you have in those accounts (75-25 is 3-1, 80-20 is 4-1). Remember this is a maximum. Just because they’re willing to loan it, doesn’t mean you should borrow it. Leverage will vary from company to company, it depends on where you are in your growth cycle, what type of industry you’re in and management style. However, the rule of thumb is most banks are willing to loan to a balance sheet with 3-1 leverage or less. If you’re higher than that, it may be difficult to obtain the financing you need from a bank.
Since much of my career was in banking, I was trained to look at both the balance sheet and the profit and loss statement. Bankers look for trends in profitability (the profit and loss statement), but also look for trends in liquidiy, activity (AR and inventory turns) and leverage (how much you own vs owe). Since the balance sheet has 3 of the 4 things bankers look at when lending, I hold the opinion that the balance sheet is more important than the profit & loss statement. What do you think?