How to Read and Analyze Your Ecommerce Balance Sheet

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Here at LedgerGurus we understand the often untapped power of the financial statements in helping business owners make more informed decisions when they're trying to run their business. The balance sheet is a great way to understand where your business stands at a present moment of time, and also understand its long-term health and vitality, how close it is to experiencing bankruptcy, and whether or not you're becoming a healthier and more sustainable business over time or less so.

0:57 A snapshot in time

So a couple things you need to understand about your balance sheet, first and foremost, is that it is a snapshot of a single point in time. So as opposed to the profit and loss that we talked about in some of our other videos, that looks at your business performance over a period of time.

So if I were to say, for example, how much money did I make, the question would be, over what period of time? Was it last year, was it last week? That's what the profit and loss covers. The balance sheet says, what were the balances of my assets, liabilities and equity as of a point in time.

So if I ask you, how much does your bank account have in it, obviously that's changing constantly. In order to answer that question correctly you would need to know exactly what period of time that I'm talking about. So if I said as of the end of last year, as of the end of last week, you could answer that question a little bit more effectively.

1:44 The three parts of a balance sheet

Second of all, you need to understand the three major parts that make up your balance sheet.

The first one are all of the assets. So assets include things like your bank accounts, your inventory, your accounts receivable, so when other people owe you money, any equipment, any land, any assets of value that you have. So assets basically being something of economic value that you anticipate giving you some sort of opportunity moving forward.

The second part that makes up the balance sheet are the liabilities. So this would be all the areas where you owe other people money. So examples of this would be accounts payable, vendors that you still owe money to, credit card debt, loans, mortgages. Those are all examples of liabilities.

And the last part of that is equity. Now people often have a hard time understanding equity, and one of the greatest ways to understand equity is to understand the way that it actually plays into assets and liabilities.

2:41

And one of the best ways I found to understand this is to understand the analogy of the house. So if I own a home and that home is worth $100,000 and I have an $80,000 mortgage against that home, then I have $20,000 of equity in that house.

And this perfectly describes the accounting equation upon which the balance sheet is founded, which is that assets minus liabilities equal equity, or assets equals liabilities plus equity. So if I have a home and it's worth $100,000 and I have an $80,000 liability against it, $100,000 minus $80,000 liability equals $20,000 in equity.

3:21 Reading a real balance sheet

Now let me show you what this looks like on an actual balance sheet.

So this is an example of a balance sheet that we mocked up for you guys. This came out of QuickBooks. Let me show you first of all how you find your balance sheet. So I would come here to reports and I would say balance sheet here, and then I would have to decide the point in time like we talked about. So in this case I want to look at my balance sheet as of the end of July, and I'm going to run the report based on that.

Okay, so here at the top I see all of my bank accounts. And because this is an ecommerce business, on top of bank accounts, the way that we account for our clients' ecommerce activity is that we also track the money that's owed to them from their payment processor. So this Amazon carried balance, for example, is basically an accounts receivable from Amazon. It's Amazon activity that you have not yet been paid out for. So this is like money that we expect to receive from Amazon at some point in the future. That would hold true of all of these other holding accounts as well. Accounts receivable being when somebody owes you money.

By the way, if I want to see this cleaned up a little bit, I would just say nonzero, and I would run this report again. Let's see, nonzero, nonzero, and it would give me just a little bit cleaner of a report on that.

4:36

Okay, so then moving on down we see my inventory here. I have a loan, some money that I lent to one of my shareholders that I anticipate them hopefully paying us back at some point in the future. All of my fixed assets, depreciation associated with those fixed assets. And I see here that my total assets are basically 6.06, just over $6 million. But remember this number, okay.

So then moving on down we see next our liabilities. So our accounts payable. In an ecommerce business or a product business this is often related to inventory that's been purchased and we're waiting to pay vendors on. Then we have various credit cards, various lines of credit, payroll taxes that we still need to pay, sales tax that we've been collecting that we still need to remit, some long-term liabilities such as loans.

And here I just want to make an indication, because it's going to matter here in a second, the difference between, you see here we have total current liabilities and then total long-term liabilities. What's the difference between the current and the long-term is that current liabilities are money that we expect to have to pay off sometime within the next year, whereas long-term liabilities are loans that we have longer than a year to pay off.

And then down below that we have our various types of equity. Now if you notice here, total liabilities and equity equals this just over $6 million, that is exactly the same as this just over $6 million in total assets. And this is how we see that accounting equation playing out inside the balance sheet, that all of our assets equals all of our liabilities plus our equity.

6:15 What the balance sheet tells you

So when we come back to this, what does my balance sheet show me? All of these things about the assets and the liabilities and the equity, why do I care, what is it showing me?

So it shows your company's financial position. So if you think about the house example again, if I owe more on my house than what it's worth, I know from a financial perspective, when it comes to my house, I'm in a little bit of trouble.

It displays what the company owes and owns. So if I had to suddenly liquidate my business and I needed to know who would I have to pay off to be able to liquidate my business. If I wanted to sell my business and they're trying to identify the value of the business, they look at all these types of things, like what are the liabilities of the business that would be going with the business, who is money still owed to, what kind of assets do we have to pay off those loans.

It shows the short-term and long-term viability, which I'm going to get into a little bit more in detail in just a second. And it also shows the health and vitality of the business. So all of these things come together to show a very complete picture of how the business is doing overall.

7:24

So these are specific questions that the balance sheet will answer. Do I have sufficient cash on hand to pay my bills? Have I invested enough in my business, or am I going to have to cough up more money personally in order to be able to make my business succeed? Does my business have too much debt on its books? Do I have stale inventory? Am I drawing out too much from my business, or do I need to reinvest more? And what is the net worth of my business?

In the day-to-day operations of a business, the profit and loss is definitely the one that adds the most insight and visibility into the day-to-day operations. But when it comes to the overall health of the business, and the value of the business if it was going to be sold, and whether or not the business is in danger or risk of going out of business, the balance sheet is really what will tell you those things.

8:15

So what shows a strong balance sheet versus a weak balance sheet? If I was investigating a business and trying to decide whether or not to buy it, or if I owned a business and I was trying to understand how healthy we were, how would I go about understanding those things?

So it really comes down to ratios. The financial statements, especially the balance sheet, are only so useful unless you then use that data, manipulate the data into these ratios that will answer great questions.

So here are some ecommerce specific ratios, also called key performance indicators, KPIs, that we recommend you evaluate and look at with your business. They are ones that will help you identify things like your working capital, which is how much money you currently have to operate your business. What kind of runway you have, so if you are losing money as a business, how much time do you have before you're basically going to be out of business if nothing changes and you keep losing money. And last of all, asset management, so how well am I managing the assets of my business and how well am I optimizing the opportunity I have there.

9:17

So this list is far from comprehensive. There are literally so many different ratios that you could look at as a business. I mean, when I went to college and we were learning about balance sheet ratios, there are literally hundreds that you can look at. But there are some that I think are specifically useful to ecommerce businesses and product based businesses in general.

9:41 The current and quick ratios

Number one is the current ratio. So the current ratio helps you understand your solvency basically, and it is calculated as current assets over current liabilities.

So let me show you in an actual balance sheet what this would look like. So remember how we talked about the difference between current liabilities and long-term liabilities. So here's our total current liabilities, here's our total long-term liabilities. So make sure in this case you're pulling from the right number.

So I'm going to look at my total current assets, which by the way excludes what I would consider long-term assets. So these are things like intangibles. These are not really things that could be bought and sold with any sort of ease, or they're not operational day-to-day sort of assets that I'm capitalizing on to sell the way I am with, like, inventory.

10:35

So if I take my current assets, and I'm going to pull up my calculator so you can see, so $5,574, divided by, and let's go down here to total current liabilities, so divided by that much, the first four numbers of that one, and I get 4.39 basically.

So what this means is that for every dollar that I owe somebody else, it means I have $4.39 of assets available to me, which is pretty good. The closer this number gets to one and below, the more of a solvency crisis you're looking at, the more likely you are to be facing bankruptcy, and the more likely you are to be facing serious cash crises.

So at first glance it would appear as though this business is actually operating pretty effectively, and that they have really good working capital, and that they're just fine from a solvency perspective, because they have $4.39 available to them for every dollar they owe to somebody else. That's great.

11:41

However, I want to show you the next ratio that I think in some ways adds even more insight into this, and it's the quick ratio.

So what's the difference between the quick ratio and the current ratio? The biggest one is that the current ratio looks at all current assets, whereas the quick ratio only looks at our most liquid current assets.

So let's go back to this and I'll show you what I mean by that. So if I scan down here through my current assets, one of the things I notice is that I have this big loan here to a shareholder. They owe us basically $1.3 million. Now depending on how easy it is for me to actually recoup that money from that shareholder, it may be the kind of thing that I can demand payment on and they have enough personal solvency and liquidity that they can just cough up that money right away. Or it may be that that's an absolute no, and that this is going to be the kind of thing that shareholder is going to need years to pay back.

12:37

Okay, so if I'm removing this, whereas the rest of these things I could probably convert into cash pretty quickly. I would expect to get paid from these various holding accounts within a reasonable period of time. My inventory asset, I could have a huge blowout sale and liquidate everything. This prepaid is another one that I probably can't really liquidate. This basically represents money that I've prepaid at this point in the year for expenses that I'm going to enjoy throughout the rest of the year. So these two are ones that I probably would not include in my quick ratio.

So let's see, and just so you know, I already ran these numbers, and basically what I got was 1363 divided by 1271, which gives me just over a dollar. So you can see that now I'm saying, in all the money that I could actually easily liquidate, I have barely more than a dollar in assets available to me over all the money that I actually owe to somebody else.

So I'm not as healthy as I would appear to be if I look at my quick ratio versus my current ratio, assuming that this money here could not be quickly converted into cash and used to pay off debt. So you can see why these two ratios are actually considered and why they're both evaluated.

Again, like I said, this is far from comprehensive in the types of ratios that you can look at. This is just quick and dirty, kind of whet your appetite on some things that you can learn from your financials.

14:04 Inventory turnover and reading ratios over time

Another one we talked about, asset management, is inventory turnover. So inventory turnover is calculated as sales versus average inventory.

Now I actually pulled up this Investopedia page to just kind of take a look at what inventory turnover can tell you, because I feel like it does a much better job of describing it than I would kind of on the fly. So basically it says that it measures how fast a company sells inventory, and that it indicates whether your relationship with inventory is sufficient or not.

The speed at which a company can sell inventory is a critical measure of a business's performance. Retailers that move inventory out faster tend to outperform. The longer an item is held, the higher its holding cost will be, the fewer reasons customers will have to return to the shop for new items.

So basically you want to be able to turn your inventory over as quick as possible. If you're sitting on a large amount of inventory, there's cost for just holding that inventory, there's cost for the risk of it becoming obsolete, and in all ways holding on to inventory, you want to move it through as quick as possible.

15:14

So if we're looking at inventory turnover, we basically look at sales divided by our average inventory. So what do I mean by average inventory?

So if I come back here to my balance sheet, I'm now going to actually show this by months instead. So let's say that I wanted to look at my inventory turnover over the month of July. Well, the balance sheet is showing my inventory balance as of the end of July. So here was my ending inventory balance, and then this, as of the end of June, would be the same thing as my beginning July inventory balance. So if I average those two things together, what I get is basically 3,592 thousand.

So if that is my average inventory, basically by taking those two numbers together, and I'm looking at sales divided by that, I would go to my, so in this month of July we had just over like $1.9 million in sales basically. And if our average inventory during that period of time was what we just described, then what we end up with is sales divided by average inventory, 3592, gives us .53.

16:29

So what this means is that we turned our inventory over .53 times during this period of time. So we basically turned over half of our inventory in the month of July.

Now inventory turnover, it's hard to just say, like in a moment's glance, whether that is good or whether that is bad. It really has to do with a lot more, like what you know about your business and the trends that you see over time. But just a couple of key takeaways on this is what it can tell you. Here we go. Low inventory turnover implies weak sales or possibly excessive inventory.

So in this case, whether that is a good inventory turnover or a bad inventory turnover really depends on the industry that you're in and what your trend is over time. But in general you want that number to be as high as it can possibly be. So if I'm watching this trend over time and last month it was 0.52 and the month before that it was a one or a two, then I know that I'm losing ground with my inventory turnover.

17:30

Inventory turnover can then be taken one step next to calculate days in inventory. I'm not going to go into how to calculate that right now. Just know that this inventory turnover is then used to calculate days in inventory, which will help you understand how many days your inventory is actually sitting there before it sells. And you want to, over time, be able to see your inventory staying there for a shorter and shorter period of time before it sells, to help you manage your business optimally.

So other examples would be, if you have accounts receivable, same types of things, like how quickly am I collecting money on my sales. Those kinds of turnovers are really valuable ways of understanding how effectively you're managing the assets of your business.

So ratios that help you understand your solvency, and ratios that help you understand your inventory and its aging and all that sort of stuff, I think are particularly valuable for ecommerce businesses.

18:27

So, reasons to watch the ratio. Now like I said, if I just flash up a number and I say this is the inventory turnover, is that good or is that bad? I don't know unless I see the way it's trending over time. So if you start calculating this, what you want to do is you want to start looking at it over time to see what it's telling you.

So for example, let's say that this is the inventory turnover that I've been calculating each month, and I can see that back in January we were turning our inventory over 3.4 times in that month, and then it slowly started to fall, and it slowly started to fall. So I can see that I'm turning my inventory over less and less than I was six months ago, and I'm trending in a very poor direction. So this actually tells me much more of a story than just this number in isolation does. And that's why looking at ratios over time, in a way that flushes out the trend, is a lot more valuable often than just looking at a measurement of a point in time.

19:30

So we can also compare to industry benchmarks. So maybe that 0.52 is just fine, maybe that's exactly what everyone else in my industry is doing. But if my competitors are doing more like this 3.4 and I'm doing 0.5, then I'm not competing well against my competitors and I'm at risk within the industry.

Also comparing to your own trend line from quarter to quarter, and setting goals for improvement over time. So if you decide that one of the things you want to do is to manage your inventory more effectively, and you want to develop a relationship with your vendors where you don't order as much and therefore you're not storing as much, and therefore you're kind of being able to buy more on demand, or in real time, or just in time, where you basically order from your vendor and it gets there and you turn around and sell it right away and you have this dialed in really really well, so you're not sitting on mountains of inventory and you're optimizing your cost in that way. You can identify whether or not you're trending in a positive direction by watching those ratios over time.

20:34

So how your ratios change, how does it affect your net worth? The bottom line increases when overall assets are increased, when overall liabilities are decreased, or when equity is earned as retained earnings. So this equity as retained earnings is a reflection of the profitability of the business, and how the profitability of the business is converting into equity over time.

So those are ways in which you can improve the net worth of your business, which not only factors into helping improve it if you were ever to decide to sell, but also the overall vitality and sustainability of the organization. So true wealth shows up on the balance sheet as a healthy bottom line in net worth. And the balance sheet is a great way to understand your own business, other businesses if you're evaluating them for purchase, or just to see how you're doing overall and whether or not your business management is improving as a whole.

If you'd like some indicators of whether or not your balance sheet is set up correctly to properly tell you what you need to know about your business, you can download our PDF, 5 Signs of Bookkeeping Trouble with an Ecommerce Business. The link will be in the description below.

If you're approaching a million dollars in sales and you're struggling with getting good information from your financials, and you don't have great bookkeeping support, this is where LedgerGurus can really help. Feel free to contact us through our website at ledgergurus.com. We'll get you on the right track and getting you all the insights you need to be able to run your business profitably.

If you like this video, hit that like button, be sure to subscribe and share with your ecommerce friends. Comment below with any questions you may have, and good luck with growing your business and succeeding.