I've been thinking a lot about balance sheets recently, and not just because of our never-ending federal debt problem. I've been watching a friend of mine—let's call him Tony—struggle to save his company. The problem can be traced to a common failing: ignorance of the balance sheet. As dangerous as that ignorance is for a country, it can prove fatal to a business. And yet, most entrepreneurs I talk to have no idea what a balance sheet is, let alone how to read it.
Tony is fairly typical in that regard. He borrowed a lot of money to start two restaurants and had plans to expand to five, but the recession put his growth plans on hold. Determined to save his restaurants, he kept close track of their profitability or lack thereof. But he paid no attention to his balance sheet. He didn't know it was important. As a result, he was unaware of just how much trouble his company was really in.
Think of a balance sheet as a thermometer that provides a reading on the health of a business at the moment you take its temperature. You can quickly determine a business's solvency, for example, by checking its ratio of current assets (those assets expected to be converted to cash within the next year) to current liabilities (those that must be paid within a year). If the ratio is less than 1 to 1, the business is technically bankrupt. Granted, there's some wiggle room. You can postpone paying some bills or speed up collection of receivables and thereby keep the business afloat. But if the ratio falls below, say, 0.8, watch out. You're well down the path to insolvency—even if your company is profitable. Cash and profits are not the same. If you run out of cash, you're out of business.
In January, Tony saw that he would soon face a cash crunch. He sent me his restaurants' income statements, along with a rudimentary balance sheet. I realized immediately that something was missing. The restaurants appeared to be marginally profitable. Why did he have so much debt? What had happened to the cash? It turned out that the income statements did not include corporate overhead. The company as a whole was losing a ton of money. The loans Tony had taken out to finance growth had instead been used to cover the losses. He was now planning to borrow more money to get the company through the looming cash crunch. I told him to forget about it. "You can't borrow your way out of debt—ever," I said.
Since then, Tony has cut costs and persuaded investors to convert their debt to equity. He has at least a fighting chance of saving the business. I hope he succeeds. I also hope his story serves as an object lesson for others, reinforcing a point I've often made: Numbers run companies. It's your responsibility as an owner to know and to understand not only the income statement but also the balance sheet of your business. You ignore them at your peril.