Do You Pay Attention To Your Balance Sheet?
By Robin Stevens, Internal Operations Coach
Most people only pay attention to their financial statements each month to make sure there revenue exceeded their expenses, but many people tend to overlook the Balance Sheet and do not have a basic understanding of its importance. Balance sheets do matter and can tell a lot about the financial health of the company.
The Balance sheet summarizes Assets, Liabilities and Owners equity in a specific point and time. It also shows the financial condition along with how much the company owns and owes. Balance Sheets along with Income Statements, are the most important element in providing reporting to banks, investors and vendors who are considering how much credit to grant to companies.
Here are the general Balance Sheet Categories
Assets: Everything of value that the company owns
- Current Assets – Can be converted into cash within one year – Cash, Receivables, Inventory, etc.
- Fixed Assets – Permanent in nature – Land, Buildings, Machinery, Equipment, etc.
- Other Assets – Intangibles such as Patents and Goodwill
- Total Assets – Total of all above Assets
Liabilities: All the debts that the company owes
- Current Liabilities – Debts due within one year from date of Balance Sheet – Payables, Loans etc.
- Long Term Liabilities – Debts due more than one year from date of Balance Sheet – Loans, etc.
- Total Liabilities – Total of all above Liabilities
Net Worth: Assets minus Liabilities – book value of the company
- Owner’s Equity Investment – Owner’s investment (cash & equipment) in the company
- Retained Earnings – Prior years’ Net Profits/(Net Losses) “retained” in the business
- Net Profit – Current year’s Net Profits (or Net Loss)
- Total Net Worth – Total of all above Net Worth accounts (Total Owner’s Equity)
Total Liabilities and Net Worth – Adds to the same amount as Total Assets; therefore Assets are in “balance” with the total of Liabilities and Net Worth.
Solvency Ratios are quick and easy to calculate and easy to understand. The objective is to know if your company has enough cash, assets and low debt to continue operating without finding yourself in financial trouble.
Quick Ratio = (Current Assets- Inventories) / Current Liabilities
The quick ratio measures the company’s ability to meet its short term obligations with its most liquid assets. The higher the quick ratio the better position your company is in. A quick ratio of 1.5 means that a company has $1.50 of liquid assets available to cover each $1.00 of current liabilities.
The quick ratio is more conservative than the current ratio because it excludes inventories from the current assets. Inventories generally take time to convert into cash, and if they have to be sold quickly, the company may have to accept a lower price than current value. This is why they are excluded from this ratio.
Current Ratio = Current Assets / Current Liabilities
The current ratio is used to determine the company’s ability to pay back its short term liabilities.
If the ratio is below 1, it raises a warning sign as to whether the company is able to pay its short term obligations when due. It doesn’t mean the company will go bankrupt, but is something that has to be looked at. If a company has a low current ratio year after year, it could be a characteristic of the industry where companies operate and high debt levels.
Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity
Long Term Debt/Equity Ratio = Long Term Debt / Shareholders Equity
Short Term Debt/Equity Ratio = Short Term Debt / Shareholders Equity
There are different variations of the debt to equity ratios, but the objective of these financial ratios is to determine how a company has been financing its growth.
A high ratio means that the company has been growing due to debt. Not all debt is bad, but if the number is exceedingly high, remember that the company has to pay off the loan as well as interest payments.
I encourage everyone to learn more about the Balance Sheet and recommended reviewing quarterly with our CPA to clearly understand your position.