How to Read Your Balance SheetJanuary 6, 2020 January 6, 2020 /
There are key financial statements that can tell you a lot about the financial health of your company. One of the most important statements, but perhaps one of the least understood, is the balance sheet.
So what is it, exactly?
The balance sheet is a snapshot in time. It shows what you own, what you owe, and the net difference between the two on a specific day. As on any given day you can buy or sell something to own, or take on new debt or pay one off, each day can give a different picture. Typically, companies will produce balance sheets on a regular basis, say yearly on December 31, or on the last day of each month.
What does it show?
Specifically, the balance sheet shows information about your assets, liabilities and owner’s equity. It’s presented in two sections – assets in one section, liabilities and equity in the other. The two sections must equal each other.
Assets are what you own that have future value and can be used to generate income for your business.
Assets are classed by how quickly, in the normal course of business, they can be converted to cash or be consumed by the business. Current assets typically convert to cash or are consumed in less than one year. Current assets include cash (of course), investments and inventory. Long-term assets include property and equipment.
Liabilities, in contrast, are legal obligations owed to another person or entity. Current liabilities are to be expected to be paid within one year of the balance sheet date. Current (short-term) liabilities include accounts payables, accrued payroll, accrued expenses and note payable payments due within one year. Long-term liabilities are typically notes payable that are due in more than one year.
Owner’s equity (also called shareholder’s equity or capital or net worth) is what is left over after liabilities are subtracted from assets. It represents the owner’s investment in the company, prior year accumulated earnings less any distributions from the company to the owners. The definition of owner depends on the legal structure of the company.
How do I use it? The importance of ratios
Beyond making sure that the net worth of your company is a positive number (i.e., you have more assets than liabilities), there are a number of other key metrics and benchmarks you can use to analyze the health of your business.
Key solvency ratios measure short-term liquidity. They tell you whether or not you can pay your debts and still have money left over to operate your business. They include the quick ratio and the current ratio.
The quick ratio measures a company’s ability to pay it’s short-term obligations with its most liquid assets. It includes what you can get your hands on in the next 30 days. The formula is
(Cash + Accounts Receivable) / Current Liabilities
The higher the quick ratio, the healthier the company. This ratio takes into account that you may not be able to sell off non-cash assets, like inventory, in time to pay off a debt that has come due.
The working capital ratio, also known as current ratio, is simpler to compute and the most commonly used. This formula is
Current Assets / Current Liabilities
If the working capital ratio is below 1, it raises a red flag that the company may not be able to pay its short term obligations when they are due. It doesn’t necessarily mean that a company is in trouble, though. If your company has a low current ratio year over year, it could just be a characteristic of your industry where companies operate with high debt levels. This is where measuring your company against industry benchmarks becomes important.
For the construction industry, some experts recommend a working capital ratio of 1.3 or better, and a quick ratio of at least 1.
Leverage ratios look at how you finance your operations – how much the company is financing itself (or you could say owner financed) and how much is being financed by other sources. There are two ways to look at it: a) the ratio of outside funds (loans) to contributed funds (equity), or b) how much equity do you have to pay off debts. The key ratio here is the debt-to-equity ratio. This formula is
Debt / Equity
Usually, you want to see a debt-to-equity ratio less than 2.0. This means your debt obligations are less than 2 times your equity investment in the business. For the record, banks place importance on how much equity you have to pay off debts. They like to see you have skin in the game.
Two other leverage ratios include the percentage of a particular type of debt over total debt. The long-term debt ratio measures the percentage of long-term debt over total debt. A high ratio may indicate that there is not enough cash to run future operations. However, some long-term debt – such as loans needed to purchase expensive equipment – may be a necessary for expansion. Short-term debt can also be reasonable. If the short-term debt to total debt ratio is high, it may indicate that you’ve paid off some long-term notes, or that you need to refinance existing debt.
Efficiency ratios measure how well you are managing your assets and liabilities, particularly in how your assets generate revenue for the company.
The working capital turnover ratio tells you how well you are using capital funds to generate sales. Working capital is current assets less current liabilities. This is your investment in the business. This formula for working capital turnover is
Sales / Working Capital
There is a preferred range for the working capital turnover ratio. Too high a ratio means there isn’t enough capital to support sales growth; too low a ratio means you’re not using what capital you have effectively. For the construction industry, a turnover ratio above 30.0 generally means you will need more working capital.
The equity turnover ratio is a similar ratio. It measures sales against total equity. This formula is
Sales / Total Equity
A result of 15.0 or below is ideal.
Putting it all together
As a balance sheet is a snapshot of a moment in time, you need to compare multiple balance sheets with each other to see where your company is going. This means looking at a minimum of three balance sheets – say, January, February and March; or year over year over year – to determine trends. Looking at them more frequently allows you to make changes more rapidly to improve your business.
What a balance sheet does not do is show you how much revenue you earned, or the inflow and outflow of cash, over a given period of time. This information is found on other financial statements. So a balance sheet isn’t going to tell you what percentage of sales was pure profit, or if you had a net increase or decrease of cash for the year.
Beyond providing you with accurate financial information, a qualified CPA will make sure you are looking at what the financial numbers tell you so that you can make the critical decisions necessary to run your company profitably.