Week 4: Your Business Is Profitable. But Is It Financially Healthy?
Updated: Sep 9
A profitable business isn't automatically a financially healthy business. A company can generate a profit while carrying too much debt, struggling to collect receivables, operating with very little working capital, or accumulating liabilities faster than assets. Those issues may not be obvious from the P&L. This is where the balance sheet becomes important.
What Does a Balance Sheet Tell You?
Your P&L shows financial performance over a period of time.
Your balance sheet shows the company's financial position at a specific point in time.
It answers three basic questions:
What does the business own? Assets.
What does the business owe? Liabilities.
What's left for the owners? Equity.
The accounting equation is:
Assets = Liabilities + Equity
Unlike the P&L, which resets each accounting period, the balance sheet carries the cumulative financial position of the company.
What's Actually on It?
Assets generally include things such as:
• Cash
• Accounts receivable
• Inventory
• Equipment
• Vehicles
• Property
Liabilities may include:
• Accounts payable
• Credit cards
• Payroll or sales taxes payable
• Lines of credit
• Equipment loans
• Other short- and long-term debt
Equity represents the owners' residual interest in the business after liabilities are subtracted from assets.
Once those numbers are accurate, you can start doing more with them.
Current Ratio
One common measure of short-term liquidity is the current ratio:
Current Assets ÷ Current Liabilities
Suppose your business has:
$150,000 in current assets$100,000 in current liabilities
Your current ratio is 1.5.
In simple terms, the business has $1.50 in current assets for every $1.00 of current liabilities.
A ratio below 1.0 means current liabilities exceed current assets, which deserves attention. But there isn't one "perfect" current ratio for every company. What's appropriate varies by industry, operating cycle, and business model. The trend can be particularly useful. Is your current ratio improving or deteriorating? And why?
Debt-to-Equity
Another useful measure is debt-to-equity:
Total Liabilities ÷ Total Equity
This helps you understand how much of the business is financed through liabilities relative to the owners' equity. Again, context matters. A capital-intensive company may normally carry more debt than a professional-services firm. Rather than assuming a particular ratio is automatically good or bad, compare it over time and understand what's driving it.
Working Capital
Working capital is even simpler:
Current Assets – Current Liabilities
If you have $150,000 in current assets and $100,000 in current liabilities, you have $50,000 in working capital.
That doesn't mean you have $50,000 sitting in the bank. Some of those assets may be receivables or inventory. That's an important distinction. If most of your current assets are unpaid invoices that are 90 days past due, your balance sheet may look very different once you examine the details.
The Ratios Are Only as Good as the Books
This is where bookkeeping comes back into the conversation. If accounts receivable isn't accurate, your current assets may be wrong. If loans haven't been recorded correctly, your liabilities may be wrong. If transactions haven't been reconciled, your cash balance may be wrong. And if the underlying numbers are wrong, calculating a financial ratio to two decimal places doesn't make it useful.
Start with accurate books. Then use the balance sheet and financial ratios to understand what's happening inside the business. Your banker may already be looking at these numbers.
You should know what they're seeing.
Clean books should give you more than accurate records—they should help you understand what's happening in your business.
If you're unsure whether your books are giving you the full picture, let's take a look. Schedule a complimentary conversation to discuss your bookkeeping and where you may need support.
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Arden Hill Partners is a DBA of Belpointe Asset Management. Investment advisory services are offered through Belpointe Asset Management, a registered investment adviser. This material is for informational purposes only and should not be construed as legal, tax, or investment advice. Business valuation and succession planning involve multiple disciplines, including legal and tax considerations. Clients should consult with their attorney and tax advisor regarding their specific situation.
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