|Assets||Dec. 31, 2010||Liabilities & Equity||Dec. 31, 2010|
|Total current assets||
|Total current liabilities||
|Total common equity||
|Total liabilities and equity||
In our previous HBS entry, we introduced readers to the balance sheet of the fictitious ABC Corporation presented above. At the time, we gave a brief explanation of each of the items on the balance sheet that you may want to review before diving into this post, which is aimed at informing you how to “read” a balance sheet for information on the financial condition of a business.
Before we get into the nitty-gritty of balance sheet analysis let’s revisit something we raised at the end of our prior post: the fact that for all businesses total assets are equal to total liabilities plus equity. Now that you know what is meant by assets, liabilities, and equity, this equation should make intuitive sense. If ABC Corp. were to sell off all of its assets it would receive $50,000; if ABC pays off all of its liabilities it will have to shell out $38,000 leaving it with $12,000, which is equal to the company’s total common equity. Thus we see that assets minus liabilities equal common equity, and some simple math then tells us that total assets are equal to total liabilities plus equity. Common equity is what is left when liabilities are subtracted from assets and is therefore sometimes referred to as the net worth of a company.
So what exactly can a balance sheet tell a small-business owner? It can help you to gauge the financial health of your company and to analyze trends that may be occurring over time. It is also one of the cornerstones of financial reporting that lenders and investors will want to analyze before deciding whether or not to provide funding to your business.
One very important figure we can calculate is the current ratio, which is equal to current assets divided by current liabilities; in our example $35,000/$18,000 equals a current ratio of 1.94. Because the current ratio measures a company’s ability to pay its short-term liabilities, it is a favorite of banks and other lenders. While current ratios will vary from industry to industry, a rule of thumb for small businesses is that lenders like to see a current ratio of at least 2.0.
Because inventory typically represents the least liquid of a firm’s current assts, we also want to gauge short-term financial health without relying on converting inventory into cash. We accomplish this by looking at the quick ratio, which is equal to current assets minus inventories, divided by current liabilities. A company’s quick ratio (in our case ($35,000-$10,000)/$18,000 = 1.39) will obviously be lower than its current ratio but it will hopefully be greater than 1.0, meaning that it can pay off its current liabilities without having to worry about selling its inventory.
Because it represents a picture of a company’s financial situation at a specific moment in time, a single balance sheet is not useful for analyzing trends. In order to do this though, we simply have to look at two or more balance sheets and see how things have changed over time. For example, are your inventories growing much faster than your revenues? If so, this may be a sign that you are stockpiling too much product at the expense of more liquid assets like cash.
You’ll also want to keep a close eye on how your receivables change over time. If they are increasing faster than your revenues, then you may need to improve your collections process and take a realistic look at who owes you money and how likely they are to pay it back. If you find that you have one or two problem customers, it may be time to have a talk with them.
Hopefully you now have an idea of what your company’s balance sheet is all about and how to read if for clues as to the health of your finances. While our discussion has been by no means comprehensive, it should have left you with an understanding of some of the most important information that a balance sheet contains. For even more detailed analysis, a college or MBA level financial management textbook can be a great resource.
101: Balance Sheets Part I
Cash Balance Pension Plans Offer Viable Alternative to Traditional 401K
Understanding Intangible Asset Values
101: Inflation Part 1
101: Inflation Part 2