Balance Sheet is a crucial report that is often disregarded by business owners. Many do not understand the importance of the balance sheet and how it can be used to evaluate the health of a business.
Breakdown of the Balance Sheet
A balance sheet is made up of 3 key elements - Assets, Liabilities plus shareholder's equity. As the name of the report suggest, the assets must always equal liabilities plus shareholders’ equity — the two sides balance out.
Assets can be further broken down into current and non-current assets.
Current assets includes your cash and other items that is easily liquidated (converted into cash) within a 12-month period. Example: accounts receivable, stocks and inventory.
Non-current assets on the other hand refers mainly to your fixed assets which will likely continue to exist in its current form (not cash) for over 12 months.
Similar to assets, liabilities can also be broken down into current, non-current liabilities as well as equity. The 3 subcategories are recorded according to the order of which has to be repaid first.
Current liabilities — those that must be repaid within 12 months — are listed first. Then non-current liabilities (due after 12 months) are listed, followed by shareholders’ funds (equity).
|Current Liabilities||Non-Current Liabilities||Equity|
As the name of the report suggest, the recorded assets must always equal liabilities plus shareholders’ equity — the two sides balance out.
Balance Sheet Financial Analysis
Here are some of the more common ratios that include balance sheet information are:
- Accounts receivable collection period
- Current ratio
- Debt to equity ratio
- Inventory turnover
- Quick ratio
- Return on net assets
- Working capital turnover ratio
Many of these ratios are used by creditors and lenders to determine whether they should extend credit to a business. [Investopedia]
For starters, we encourage our users to evaluate their company's Current ratio on a quarterly/annual basis. The current ratio indicates a company's ability to pay short-term and long-term obligations.
Current Ratio = Current Assets / Current Liabilities
In general, it is most desirable for a company's current ratio to equal '1'. A company with a current ratio less than '1' does not have the capital on hand to meet its short-term obligations if they were all due at once. On the other hand, if a company has a very high current ratio compared to their peer group, it indicates that management may not be using their assets efficiently. – Investopedia
It is important to note that there are certain industries such as retail where having current ratios below '1' would be considered a norm. This is due to the higher receivables turnover than payables turnover in such industries. (Money is quickly collected from customers but have a lot of leeway when paying off debt).
Now that you understand the function of your balance sheet, let's get right into evaluating the health of your respective businesses - Login to Financio