Are you reading your balance sheet the right way?
The balance sheet is a financial statement that provides a snapshot of your company’s assets, liabilities, and owner’s equity on a specific date. It shows what you own and what you owe, and provides creditors, suppliers, investors, and others the ability to see the financial position of your company. The balance sheet is sometimes referred to as the statement of financial position.
The balance sheet is one of the three required financial statements in addition to the Income Statement (P&L) and the Statement of Cash Flows.
First, a quick review of the balance sheet
Assets = Liabilities + Owner’s Equity
Let’s break each of those down into just a little bit more information….
An asset is something you own. It provides a future economic benefit and may be something paid in advance like prepaid insurance.
Examples of assets listed on the balance sheet would be cash, accounts receivable, inventory, supplies, petty cash, and equipment.
Often, assets are broken down into classifications that show the timeline for planned use such as current assets, investments, and plant, property, and equipment (PP&E). Current assets are accounts like cash, inventory, and accounts receivable – representing what will be used within one business cycle.
A liability is an obligation or something you owe. It is considered a source of your company’s assets.
Often the names of liability accounts have the word ‘payable’ in them – accounts payable, salaries payable, etc.
Liabilities are also broken down into classifications that show the timeline such as current liabilities and long-term liabilities. Current liabilities are due within one year.
Owner’s equity (or the book value of your company) refers to the owner’s claim once all the liabilities are paid off. Like liabilities, owner’s equity is also a source of assets for your company.
Owner’s equity is equal to the assets of your company minus the liabilities. By rearranging the equation above you can arrive at this:
Owner’s equity = Assets – Liabilities
Some helpful ways to analyze the Balance Sheet
Calculate ratios & margins to get to an “apples to apples” number
1. Working Capital
This equation tells you the ease in which you can access cash and pay bills. By taking your current assets (like cash) and subtracting current liabilities (like invoices due within 30 days) you will get to the working capital balance.
2. Current Ratio
The current ratio tells you the relationship between current assets and current liabilities. You want a higher ratio because it shows you have more working capital.
3. Quick Ratio
The quick ratio gives a glimpse of the ability of cash on hand to pay off current debts. If it is 1 or higher, it shows your company can pay of short-term debt obligations.
4. Debt to Equity Ratio
The debt to equity ratio measures your company’s leverage by assessing your company’s growth strategies.
Other things to look at in your balance sheet
If you carry inventory, this is a helpful metric for determining how quickly your company is moving through product. If this number is too low, it means you may be sitting on too much inventory. If it is too high, it means your company may be missing out on sales by not keeping product in stock.
Inventory turnover = Cost of Goods Sold (COGS) / average inventory
(hint: don’t forget to find your COGS number in your P&L)
Depending on your type of business, you may carry a substantial accounts receivable balance. When analyzing the balance sheet, one thing to look at is accounts receivable. If this number is growing, it’s a sign that you may need to reassess your outstanding accounts and tighten your terms with customers.
It is helpful to calculate the average collection period, which is the length of time it takes your company to collect accounts receivable from customers.
Average collection period = accounts receivable / annual total revenue * 365
Always look at your balance sheet alongside the P&L & cash flow statement
Without comparing the balance sheet to other financial statements (the P&L and the statement of cash flows) it is hard to see the full picture of your business.
As you continue to operate your business, keep these tips in mind to maintain control of your financial position.