The Importance of Balance

March 18, 2015

 

Today I'm focusing on your balance sheet. Believe it or not, your Profit and Loss is not the best indicator of the strength of your business. You need to focus more on your balance sheet and strengthening this position.

Strengthening Your Balance Sheet 
Building a sound balance sheet, with adequate cash to finance not just day-to-day expenses but unexpected expenses, is a critical element in any growing company's development. 

A healthy balance sheet allows companies to expand, whether through internal initiatives or strategic acquisitions. 

(1) How much cash do you need? 
For starters, companies need to understand their working capital needs. Working capital is the difference between current assets and current liabilities. You want to make sure that your company has enough short-term assets to cover short-term liabilities-in other words, enough cash and collectible receivables on hand to run the business. In addition, though, you may want to have cash on the balance sheet as a form of growth capital in reserve. This additional cash can fund expansions in plant and facilities, R&D, or other growth initiatives. When you have cash on your balance sheet to fund these initiatives, you may not have to borrow additional funds to expand. In fact, just having additional cash can make it easier to borrow. 

(2) Can you have too much cash? 

In general, additional cash on the balance sheet is positive, since it gives you the flexibility to pursue a variety of opportunities. However, remember that this cash will only earn a modest rate of return, most likely less than 2 percent. Investing in the growth of your business will almost always generate a higher return than holding cash. If you have a good amount of cash on the balance sheet for an extended period of time, your return on equity may be lower than it should be. 

(3) How much debt can you take on? 

Strengthening the balance sheet does not necessarily require eliminating or even reducing debt. In fact, debt is an important part of nearly any company's capital structure. Many companies are actually under-leveraged. They would be far more efficient, from a capital structure point of view, if they were to borrow a modest amount of money. 

Companies whose cash flows fluctuate substantially from quarter to quarter may need to be more conservative in the amount of leverage they take on, so as not to risk violating a covenant - or worse, missing an interest or principal payment during lean periods. 
Structuring your balance sheet effectively provides a sound financial foundation, offering the resources for your company to meet its current operating needs and plan for the future. Make sure that you take some time this year to focus on this part of your business as well as on your profitability.
If you have any comments on any of my discussion pieces, please let me know or leave a message below. Also, if you would like any specific topics to be addressed in this blog, please let me know.

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