Where the P&L tells you how well you are doing during a certain time period, the balance sheet shows how well you have done for the life of your company. The P&L gives you the score for an inning. The Balance Sheet gives you accumulative score for the whole game – plus a whole lot more.
Most business owners have a good feel for their P&L (Profit and Loss Statement, a.k.a., Income Statement). But very few use their Balance Sheet for anything more than just keeping track of what they have and what they owe (assets and liabilities).
One key performance indicator that is very important to understanding the financial strength of a company is Working Capital. Working Capital is simply short term assets minus short term liabilities. It tells you what kind of asset coverage you have for your current debts. Generally if you have less short term assets then short term debt, you are considered to be insolvent and would probably be unable to get bank or other external financing. With short term assets at 1.5 time current debt, you are generally considered to be in adequate shape and higher is better.
However, it is more important to know where your Working Capital is headed then it is to know your current status. That’s where trend lines come in. In particular, the Working Capital trend line can tell you a lot about the health of your business. Most importantly, it tells you whether a company is building or loosing financial strength.
For the purpose of the illustrations below, assume that the Target Minimum line is set at 1.5 times the company’s short term debt.
Working Capital trend lines are considered "healthy" as long as they are above the Target Minimum or on their way to being above the Target Minimum. Even a falling Working Capital line is healthy as long as it is above the Target Minimum because it implies that the company is using available resources to build for the future.
Working Capital trend lines are unhealthy when they are below the Target Minimum or have recently dropped below the Target Minimum. This simply indicates that a company lacks the resources to pay its bills. And if the Working Capital trend is below the Target Minimum and heading down, it shows that the condition is getting worse and is on its way to insolvency.
Companies that don’t have visibility of their trend lines are often surprised when they find out they are in deep financial trouble. It’s not enough to know that your financial ratios are fine as of your latest financial report. Good numbers that are headed in the wrong direction are not good! Way too many companies find themselves out of business because they just didn't see it coming.