Today we are going to look at optimising your balance sheet to maximise returns and increase the value of your business.

The balance sheet is an often neglected place for small businesses, that means there’s usually quite a bit that can be done to optimise it.

The reason many small businesses fail to optimise their balance sheet is because they are only focussed on the income statement.

Business owners are leaving money on the table by not optimising their balance sheets.

In this edition we will look at:

• Fixed assets

• Net working capital

• Equity financing

• Debt financing

Fixed assets

Fixed assets are items which are purchased for long-term use. These can include plant, property and equipment.

A little while ago, I was speaking with a couple that ran a family business. They wanted to grow and to do so they wanted to purchase a piece of equipment that cost millions. This machine would be the second one they owned and it would increase their production capacity. The business was flourishing so it sounded good. Right?

As it turns out Mom and Pop were the main operators of their existing machine and they were running the machine at full capacity. So they thought a second one could be purchased and it would increase business immediately.

But a bit more probing revealed some interesting facts. Mom and Pop had staff but those people merely assisted with production. So Mom and Pop would work their butts off all day, from early in the morning till late at night and always have a backlog of work. But the machine was idle all night long.

You see, Mom and Pop thought they needed another expensive machine to cope with the workload, but their real problem was that they had not trained staff to operate the equipment skillfully. If they had done that, they could have run an extra shift on the existing machine and met demand, without purchasing a second machine.

The Golden Rule is do not purchase fixed assets unless you really need them. If you do so, you grow your balance sheet with sub-optimal asset usage. This reduces your return-on-equity.

Net working capital

For our purposes Net Working Capital (NWC) means:

 NWC = Inventory + Receivables – Payables

Your aim is to minimise your investment in NWC because lower NWC contributes to higher return-on-equity.

Inventory

Inventory is the stuff that your company makes. You often have inventory in stock to ensure a steady supply, but this costs money because you produce the item and then hold onto it until it is sold.

The biggest sins with inventory are to be holding stock of items that:

1. are not in demand, or

2. that can be manufactured quickly.

Small businesses are often guilty of holding lots of inventory of all types. The best way to optimise inventory holding is to analyse what moves and what does not. Hold only what you need as this will reduce your investment in inventory. This analysis is easy as there are online tools into which you can feed your data and they will show you what the optimal stock levels are.

Receivables

This is also known as debtors and is the money owed to you for products that have been purchased from you. The less that is owed to you, the less you have to finance.

You probably have to give your clients payment terms. But thereafter, you are responsible for collecting the money on time.

Easy ways to collect your cash include using a system to invoice immediately the product is shipped. Have the system send follow ups with reminders about the final payment date, including a countdown in the final week. Individuals and companies will often pay before the due date if they receive reminders.

If someone misses the payment date, get on the phone and politely ask what is happening. The sooner you receive your money, the better.

Payables

Payables are also known as creditors. These are the businesses that you owe money to. There is always a temptation to maximise these and stretch them out as much as possible.

If your supplier gives you terms, you are free to use them. However, be cautious about over-stretching it. No one wants to do business with someone from whom they struggle to get payments. So don’t do that.

Also find out if discounts are available for early payment. Sometimes the discount can exceed the benefit of stretching the payment dates.

Equity financing

Equity financing refers to either the equity investment you made by buying shares in your company or to retained earnings.

Equity financing is generally more expensive than debt. Use equity financing where necessary but also consider your alternatives.

For instance, I know of a cash flush company that wanted to purchase property and vehicles with cash. The cash was from retained earnings, so it was equity financing. Yet both of these assets can be debt financed quite easily.

Remember - lower equity means higher return-on-equity. While I am not suggesting that you borrow too much, I am suggesting that you consider all financing alternatives for assets.

Debt financing

Debt financing refers to loans. Debt financing is cheaper than equity financing and the more debt you have, the higher your return-on-equity. However, too much debt comes with the risk of bankruptcy. So debt has to be used in a considered manner.

The best way to use debt is to use it for productive purposes. For instance, purchasing cash generating assets is productive. On the other hand, paying expenses with debt is not so productive. Good debt can include property finance, vehicle finance, working capital finance and equipment loans.

Conclusion

In order to optimise your balance sheet, you want to:

• Purchase fixed assets only when truly needed.

• Manage your net working capital.

• Minimise the use of equity (but don’t borrow too much).

• Use debt appropriately to purchase productive assets.

At the end of the day, the longevity of your business matters and so does your peace of mind as a business owner. If you are unsure or uncomfortable, don’t borrow. But remember debt can be beneficial if used appropriately. If you optimise your investment in assets and how they are financed, you will increase your return-on-equity and the value of your business.

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