Recently, I presented to a Vistage Key Group and spoke on how the balance sheet enables business owners to better understand the health and well-being of their companies. Originally, I had developed this presentation upon soliciting ideas for presentation topics from entrepreneurs. What I found was that while many understand income statements and cash balances, they sought a deeper insight into the balance sheet, how to read it and what it says.
When it comes to painting the picture of a company’s financial condition, revenue and earnings are just part of the picture. Often referred to as a snapshot of a company’s health, the balance sheet discloses what an entity owns or controls, what it owes and what the owners’ claims are at a specific point in time.
Think of this basic accounting equation: Assets = Liability + Equity. The left side of the equation (assets) reflects the resources controlled by the company, and the right side (liability and equity) reflects how those resources were financed.
What to Include on a Balance Sheet
The financial position of a company is described in terms of its basic elements (assets, liabilities and equity). Account balances can be debited or credited which can increase or decrease the account balance depending on which side of the balance sheet the account resides. Debits increase assets and decrease liabilities, while credits decrease assets and increase liabilities.
Accounting standards require that certain specific line items, if they are material, must be shown on a balance sheet. Among the current assets’ required line items are cash and cash equivalents, trade and other receivables, inventories, and financial assets (with short maturities). Companies present other line items as needed, consistent with the requirements to separately present each material class of similar items.
In addition to current assets, you should also show long-term assets, such as fixed assets. These can either be tangible assets, such as land, buildings, equipment and machinery, or intangible assets, such as patents, developed software, goodwill and copyrights.
Some of the common types of current liabilities, which are typically due in less than a year, include accounts payables, accrued liabilities, accrued expenses and deferred revenue. Examples of long-term liabilities are loans, notes or bonds payables, and deferred tax liabilities, which are the amounts of income taxes payable in future periods with respect of taxable temporary differences.
When including equity related items, make sure to include capital contributed by owners, preferred shares, treasury shares and stock, retained earnings, net income and minority interest.
How to Use the Information
So how do you read a balance sheet to find the health and well-being of a business? Liquidity and solvency ratios are used to find out how liquid and solvent a business is based on various areas of the balance sheet. Here are some examples.
Liquidity ratios are those involving short-term payments. Examples include:
Current Ratio (expresses current assets in relation to current liabilities)
Current ratio = Current assets ÷ Current liabilities
Quick Ratio (expresses the more liquid current assets in relation to current liabilities)
Quick ratio = (Cash + Short-term investments + Receivables (net)) ÷ Current liabilities
Cash Ratio (expresses cash and marketable securities in relation to current liabilities)
Cash ratio = Net cash provided by operating activities ÷ Average current liabilities
Solvency ratios are those involving long-term payments. Examples include:
Debt to Equity Ratio (measures percentage of total assets provided by creditors:
Total debt to total assets ratio = Total debt ÷ Total assets
Interest Coverage Ratio (measures ability to meet interest payments as they come due)
Times interest earned = Income before income taxes and interest expense ÷ Interest expense
Debt to Assets Ratio (measures long-term debt paying ability on a cash basis)
Cash debt coverage ratio = Net cash provided by operating activities ÷ Average total liabilities
Additionally, there are other working capital data points that you can get by combining information from both the income statement and balance sheet. These include:
Receivables turnover = Net credit sales ÷ Average net receivables
• Measures liquidity of receivables
Collection period = 365 days ÷ Receivables turnover
• Measures number of days receivables are outstanding
Inventory turnover = Cost of goods sold ÷ Average inventory
• Measures liquidity of inventory
Days to sell inventory = 365 days ÷ Inventory turnover
• Measures number of days stock is on hand
Whether a company needs to report its financial condition to lenders, board members or the internal team, balance sheets enable business owners to quickly get a handle on the company’s strength and capabilities. Through regular, consistent review throughout the year, business owners will be more in-tune with the company’s financial pulse, enabling them to make better, more informed financial decisions.