As a “developing” business owner, it took me a long time—and a lot of repetition from my accounting and financial professionals—to stop attempting to determine the health of my business from the Income Statement alone and temper my decisions by pairing the information found on the balance sheet.
During the early and even through the mid-stages of our business experiences, we typically think of the Balance Sheet as something we pull out and dust off when it’s time to increase our line of credit, or get a loan to buy that new refrigeration unit (or maybe benchmark something against an article we just read) and then go back to the income statement for the perfunctory, “how we’re doing so far.”
However, that health number we are typically looking to on the Income Statement (Net Profit) is already stated on the balance sheet, where far more complete indices of your business are also contained. So, making “balanced” decisions in reaction to or planning for are often better served with a financial workflow that begins with the Balance Sheet for broad overview and then supported by the review of the Income Statement for granular detail.
As a quick summary, financial (and tax) professionals are generally reviewing one year’s balance sheet over the previous, then looking to see how we got there from the information provided by the Income Statement. Because the Balance sheet reflects the business’ financial transactions (or decisions) over the entire life of the business, whereas the Income Statement simply states where we have made and spent our money for a specific year, if we focus on the Income Statement as primary for our decision making, then we risk many different kinds of errors to solve what are often “acute” problems, and using solutions generated from the “Income Statement alone” may not be in the best interest of the future state of the business. Because Income statement solutions are condensed to within only one year of a business’ life, think how much pressure you feel or what you might consider sacrificing by believing you have only one month or quarter to solve a problem? What might change if you understood that you have a year to fix it? So, the balance sheet better assists the majority of problem-solving purposes because TIME is more comprehensively represented on our Balance Sheets.
The next important distinction is the Balance sheet is what tells us what the company owns and what it owes, and even what it’s owed at a specific point it the company’s timeline. To fill in the gaps between one point in time and another, the Income Statement tells us where we made our money during that period, where we spent our money, and most importantly, is there any money left over at the moment?
There’s also a psychological benefit to starting with the balance sheet. For better or worse, looking again to that one number that connects our Income Statement to the Balance sheet (Net Profit), it’s placement on the latter part of the report is actually another component of keeping balance in our business decisions.
When we begin our financial reviews at the Balance Sheet, we first encounter what we have accumulated in cash, what’s still owed to us, and any other items of value, we always have an idea of what we can convert should we begin having rainy days and gives us a foundation of confidence. Conversely, we don’t get lulled into a false sense of security because the Income Statement shows a profit, but is “forgetting” about those monthly loan payments right around the corner. That’s a good Segway to the next section where we see what we owe to other people, in the form of bills, those loans, or other types of indebtedness (deposits, pass-throughs, etc.). If we’ve done a good job of managing our money then we can see how many times those fast-convertible assets can be used to pay off all our relatively time-sensitive obligations, say maybe twice over (or a ratio of 2.0). Conversely, had we been having a challenging time and are playing much closer to the vest, we can still be afforded information that provides proportionality to the challenges and dampens our immediate reactions for clarity of thought.
As we begin to really grow our businesses, when our Income Statements begin to show downturns our reactions are often to immediately cut and “save.” But because growth frequently involves the “step-costs” to leap from one “level” to the next, that cutting frequently has disastrous affects on our ability to safely “clear the gap” between those two levels. At the root, the challenge we are really having is “do we have enough cash for the time we need for our revenue to catch up to the new increase in costs we’ve taken on?” When we supplement the information from the balance sheet, we better understand things like working capital available to cover costs or, most importantly, the length of our runway before running out of cash. Again, we’re back at the subject of time.
Like many discussions on “what’s the best (insert whatever here)” the answer is often meaningless due to omissions of context. However, I would argue here that, for understanding your business and making ANY important decisions, the best process is to regularly start your financial reviews with your balance sheet and pair that information with the Income Statement. Then, balance any decisions for cutting expenses with considerations of investing (taking on debt or using personal capital) or even restructuring some of those assets. In short, always reviewing your Balance Sheet and Income Statement as a pair affords you a balance of appropriate actions within specific periods of time.
As the saying goes, two heads are better than one, and committing to a Balance Driven Business keeps you at pace in this new world of business— the ever-increasing speed in which business adaptations need to occur to realign people, product, and profit. Col. Sudip Mukerjee of Reserv3 Consulting and Sean Lewis of SLC Advisory Group combine their specialties for the deep dive needed to bring your business up-to-date with the finance and people challenges of the New World, and to lay the groundwork for staying competitive well into the future.