Often times, companies focus on their income statement and cash flow statement without considering the balance sheet. This is a mistake! The balance sheet is important because:
– Shows the effect of past decisions.
– Track the liquidity of a company’s cash position
– Records what is the position of the owner’s equity in different time intervals
– Directly affected by the statements of cash flow and results, which reflect the state of operation of the company.
– Quickly show the status of a company.
The Balance Sheet illustrates how the assets, liabilities and equity of a company are distributed at a certain point or period of time. The Balance Sheet set format makes analysis easy. The order of the detailed categories of the Balance Sheet is organized in the order of Decreasing Liquidity and Immediacy for Assets and Liabilities respectively. Because the Balance Sheet shows changes in Debt, Equity and the condition of the Company over time, it is an excellent document for monitoring and control. Before we get into the balance sheet analysis, let’s examine the important sections of the balance sheet (see the sample balance sheet (simple format) at the end of this article).
– Current assets: Cash, Government and negotiable securities, Notes receivable, Accounts receivable, Inventories and Expenses paid in advance. Any other item that can be converted to cash within a year.
– Fixed Assets: Land, Plant, Equipment, Lease Improvements. Other items that are expected to have a commercial useful life that can be measured in years.
– Depreciation applied to items that wear out.
– Other assets: intangibles such as copyrights, patents, contract exclusivity and promissory notes receivable from company employees and officials.
– Current liabilities: accounts and documents payable; Expenses that accrue (such as wages, salaries, withholdings, FICA); Taxes payable; Current portion of long-term debt; and other Obligations that mature within one year.
– Long-term liabilities: trust deeds, mortgages, equipment loans, and long-term bank loans. All of these are Net of the current portion of Long-term Debt (shown as Current Liabilities).
– Equity: Assets minus Liabilities.
– Participation of the owners: Participation of capital of the principals, Retained earnings and other Participations.
Balance sheet analysis
Three ways to quickly determine the health of your business:
1) Analyze working capital: Subtract current liabilities from current assets to determine your level of working capital. Cash is only part of working capital.
a) Illiquid companies may have difficulty obtaining future loans. The solutions are working capital loans, sale of fixed assets, financing of accounts payable or obtaining new capital investments.
2) Compare Fixed Period Balances – By comparing similar time periods, you can quickly spot trends and weak areas, which after researching, you can determine the reasons driving them. If you are an established business, compare year-end balances. If you’re a new business, compare your balances from one quarter to the next. Upon analysis, problem areas and strong areas pop off the paper.
3) Acid and Current Test Ratios: These analyzes are based on percentages versus dollars, so it’s easy to compare to industry and area standards for similar companies.
a) Current ratio: measures the liquidity of a company or its ability to meet current obligations in the next year.
I. Formula: Current assets ÷ Current liabilities
ii. For analysis to mean anything, it is important to understand what this relationship represents. Factors that affect the current relationship are the type of inventory, the quality of the accounts receivable, the sales cycle time, the time of year, etc. A ratio of 2.0 generally represents a healthy company, but it really depends on the type of company and the industry.
b) Acid Test: The “Quick Ratio” is calculated by dividing the most liquid assets of a company by the current liabilities. Liquid assets include cash, securities, and current accounts receivable. A ratio of 1.0 generally represents a healthy company, but is company and industry specific.
Note: A current ratio of 2.0 and an acid test of 1.0 (fast ratio) are not industry specific. Be sure to research the healthy levels of companies that closely resemble yours. Trade associations, banks, and Dun & Bradstreet are good sources of comparative ratio information.
Footnotes: Assumption and calculation footnotes are very important to an outside reader, such as a banker. A bank would be interested in how restricted its Assets are, so an explanation for each Asset item would be in order. An investor would be very interested in the details of the owner’s equity. A banker would also be interested in a breakdown of accounts payable, detailing exactly when liabilities are due.
Balance Sheet Example (Simple Format)
• (Less) accumulated depreciation
• Net fixed assets
Long term passives
Net worth / Owners’ equity
Total liabilities and equity