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A balance sheet is an important tool that can help determine your company’s health, no matter its size.
Balance sheets are just as important to small and medium home builders as they are to large public builders. But while the bigger builders evaluate every business decision they make based on how it will impact their balance sheet, smaller private builders often ignore or overlook their balance sheets.
For private builders, that can be a costly mistake. Many decisions that can affect a builder’s future — even his survival — are based on information contained in a builder’s balance sheet.
While you probably have no intention of selling stock in your company, a balance sheet can point out your company’s financial strengths and weaknesses. It indicates how you have invested your resources as well as your likelihood of attracting additional needed resources — loans and investments — from lenders and third parties.
Third parties use the information on your balance sheet to make decisions about your business that can impact your success, so don’t ignore it. Moreover, you must not only understand this important income statement, you need to evaluate your business decisions based on their potential impact on it as well.
Use your balance sheet to evaluate your company’s growth potential using internal or third-party resources.
Also, in these tough times, use your balance sheet to determine whether you can survive by comparing ratios from income on your statements with your balance sheet to determine how efficiently, or inefficiently, key areas of you company are operating.
These key areas should include:
- Inventory turnover — cycle-time efficiencies
- Capital turnover — efficient use of your investment
- Working capital turnover — efficient use of liquid resources
By relating sales revenue to accounts in your balance sheet, you can calculate turnovers. When calculating your business’ effectiveness, remember that you are compensated two ways — with your salary and your return on investment (ROI).
Your balance sheet presents the value of the owner’s investment. Evaluate whether your business earns a higher return on capital investment than if you invested elsewhere, such as in a money market account, bonds or stocks.
The relationship between net profits from your income statement and your investment will provide the return, as indicated by the following equation:
Return on Investment =
Return and risk correlate closely — the higher the risk, the higher the expected return; and conversely, the lower the risk, the lower the expected return.
Given the high risk in the home building industry, what return is reasonable? Are you getting a reasonable return on your investment and, if not, how can you improve it?
The first step toward improving your ROI is to monitor the return. Establish a target return and focus on achieving it. Understanding how your income statement and balance sheet interact can guide you towards achieving your goal.
Understanding Your Balance Sheet
A balance sheet lists the assets or things of value that the company owns as well as who paid for those assets — the owner, third-party creditors or both. Assets are purchased with the owner’s “patient” capital or the creditors’ “impatient” capital.
The owner’s investment is known as “patient” capital because owners usually intend to use the invested capital to grow their business or sustain operations. In contrast, creditors want to collect their invested capital, and in most instances, a return on their investment, within a reasonable time.
As an owner, you can grow you patient capital — also known as owner’s equity — by making additional investments in your company with cash, land or equipment. You can also invest in your company by keeping your net profits in it. This enables you to grow your company without having to borrow from lenders or creditors.
You also can withdraw your earned capital from your company.
Keep in mind, however, that you will be pressured by some to keep your profits in your company and by others to take your profits out.
Typically, lenders and creditors will want you to keep your profits in your company in order to decrease their investment risk.
However, since owner’s capital is always at risk — particularly from buyers and frivolous lawsuits — when it is left in the company, as an owner, you may want to extract all your capital except what you need to maintain normal operations. This strategy, however, may raise your lenders’ risk to a level higher than what their lending rules allow. Consequently, your lenders may require personal signatures to mitigate this risk and to guarantee your business loans.
Also, keep in mind that when determining your company’s profitability, profits are not compensation for work done. Working owners are entitled to compensation and these payments are not considered withdrawals from profit.
The assets listed in the balance sheet include cash; accounts and notes receivable (the right to collect cash); investments; inventory including materials, land, homes under construction and finished homes; prepaid expenses (the right to receive a service in the future); office furniture and equipment; vehicles; and other miscellaneous items of value.
Converting Assets to Cash
There is a hierarchy for converting assets into cash during normal business operations. Obviously, the office furniture, equipment and vehicles are not meant to be converted into cash; they are for business operations.
Inventories and the accounts and notes receivable are presumed to convert to cash in the near future. These are referred to as current assets.
On the liability side of the balance sheet, or the impatient capital, there are two types of obligations — those due within the next 12 months and those that can be repaid over several years.
The obligations that must be paid within the next 12 months are called current liabilities and, under normal operating conditions, you are expected to convert current assets into cash within the next 12 months and pay the current liabilities within the same time period.
A comparison of current assets to current liabilities yields a ratio that indicates the likelihood that your company can repay its current liabilities. This current ratio is commonly regarded as a measurement of liquidity or solvency — your company’s ability to meet creditors’ demands, whether these are loan payments or other accounts payable.
Current Ratio =
Lenders are not interested in giving their money away without any hope of getting a return on their investment. Your company’s ability to pay back the money is an important consideration in making a loan or providing credit. Liquidity coupled with the risk factor, as measured by the relationship of debt to your capital or equity, will determine your company’s strength and its ability to borrow money.
Debt to Equity =
_ _Total Debt _
You can never afford to lose your company’s ability to borrow cash from third parties. Cash is king and as a company owner and manager, you must control the spigot providing the cash.
Measuring Up to Your Competition
“The Cost of Doing Business Study” enables home builders to compare profitability, cost of sales and expenses with like-sized builders from across the county. When evaluating your business, make sure you compare your company’s performance using the three ratios explained in this article and use the best-performing companies to establish company goals.
Owners whose companies exhibit high performance ratios on their balance sheets will enjoy significant peace of mind, particularly during tough times, because their companies will be the survivors.
Emma S. Shinn, MBA, CPA, is a business and accounting consultant with The Shinn Group based in Littleton, Colo. She also is a past chair and contributor to NAHB’s Business Management & Information Technology Committee. For more information, call Shinn at 303-972-7666, or visit www.theshinngroup.com.
The article will be featured in the upcoming “Cost of Doing Business Study” to be released at the 2010 International Builder’s Show in January in Las Vegas. The study enables builders to compare their balance sheets with other builders around the country. It can be purchased through Builder Books.com.