Why do SMEs need to understand their balance sheet?

For years we’ve seen many SMEs who do not produce regular management accounts, which we would argue are far more important to the small company than year-end accounts.

Too many SMEs rely on the profit and loss and do not put enough time into understanding their balance sheets.

Yet it is the balance sheet that tells a business what is really in the ‘tank’ which is more than simply the cash in the bank. Current assets and in particular those like recent debtors, work in progress and easy to sell stock that can all be quickly turned into cash are key. The other item to monitor is current liabilities such as trade creditors and HMRC liabilities. Withholding payment can provide temporary respite and even improve the cash balance in the bank but creditors don’t go away.

A related issue is that a lot of SMEs are reliant on factoring or invoice discounting their book debts which essentially means that there is little cash to come back to them when the book debts are paid. All too often such companies have large liabilities without current assets to service them so they become reliant on new sales or prepayments which are in fact another liability.

If, for example, a business has book debts of £10,000 which are factored at 70% and a liability to trade creditors of £5,000, it has a problem because it really only has £3,000 to pay the trade creditors since the factoring company will keep £7,000 of book debts when they are paid.

It is crucial for all SMEs and in particular those planning to grow to understand their balance sheet and ensure that they have sufficient cash to fund growth without over trading, ie running out of cash.

I shall address monitoring the balance sheet and possible key indicators in a future blog.

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