Why reading a balance sheet is important for business growth …
Learning how to read a balance sheet is one of those essential management skills that business owners must have if the business is to succeed.
Reading the balance sheet is an essential part of business management and provides a business measure you cannot do without.
Understanding your balance sheet is one of those business management basics that ensures you know how to properly manage your business.
If you don’t understand how reading a balance sheet provides vital information on the health of your business then you should learn to read a balance sheet
Analysing your balance sheet properly will tell you if your business is capable of funding its own growth or needs to take on debt.
Do you have too much inventory and are you collecting the money that’s owed to you by customers, on time?
Understand your business balance sheet and you will have all this information at your finger tips.
Let’s have a look at the components of a balance sheet based on our Business Balance Sheet Example.
1. Current Assets
Anything that can be converted to cash within the business year. This includes …
- Cash. Money in the bank or the equivalent.
- Investments that are short term, like bonds.
- Accounts Receivable. All monies owed to the company by customers who have bought on credit.
- Inventories (stocks). All raw materials, work in progress or finished products that are ready for sale. Remember that inventory ties up capital so never over stock.
- Prepaid Expenses. Anything that has already been paid for. Deposits paid or pre-payments for advertising or marketing expenses are prepaid expenses. Generally a good thing.
2. Fixed Assets
Anything that is not liquid and can’t be converted to cash quickly and easily.
These assets are used to operate the business, such things as land, buildings, vehicles, plant and equipment etc. are fixed assets.
- All of these items are subject to depreciation on the books.
- This will include intangible assets such as goodwill, patents, franchise rights and other items.
- Other assets is where you put those items of a fixed nature that you don’t know where else to put, such as life insurance.
Now we look at the other side of reading a balance sheet.
3. Current Liabilities
All that you owe to your creditors and suppliers forms part of your current liabilities. By current we mean due and payable within one year.
- Short-Term Notes Payable. Includes bank credit repayments and any long-term debt repayments falling due.
- Accounts Payable for all raw materials, goods and services, wages, salaries etc.
- Accrued Expenses. Work you have had done or money that you owe but not yet paid. This could be for income tax, unpaid overtime due, stock holders dividends and periodic distribution expenses etc.
- Long-Term Debt. If you owe interest on money which is not due yet, this is where it will go.
4. Stockholders and Shareholders Equity
Only two items, really only one to note here.
- Common Stock … All the shares in a business normally held by the founders or management. The value shown is the amount paid to acquire the shares and not the actual value. Recorded purely for accounting purposes.
- Retained Earnings … records the total cumulative amount of capital earned by the company since it started less any and all dividends paid out to the shareholders. This is the one to note. This is where you take profit from your business.
Using Balance Sheet Ratios … When reading a balance sheet
Here is how to extract some meaningful information when reading a balance sheet. Information that will help pay you back for all your hard work.
When you read a balance sheet properly it is full of clues to how well your company manages its assets and it is well worth spending some time on measuring your business based on a number of ratios.
Here are the basic balance sheet ratios …
- Current Ratio will show the amount of liquidity, ie; assets in the form of money or that can be converted easily into money, that your company has available.
- Current Ratio = Current Assets divided by Current Liabilities
- For example, our balance sheet for year one gives a current ratio of …
Current Assets Current Liabilities Ratio 705,000 449,750 1.57
- Any current ratio of 1.5 or greater is considered good enough to meet the operating needs of the company in the near-term.
- You don’t want the ratio too high, as this shows that you are not properly using the company assets to grow the business.
- By the way, in year two of our business balance sheet, our current ratio is 2.3, those assets should be working harder.
- Quick Ratio. Here we look at the liquid assets of a company less its inventory (stock). Why you might ask, well inventory can tie up liquidity and you can’t run a company on inventory.
- Quick Ratio = Current Assets – Inventory divided by Current Liabilities
- Our example shows the following for years one and two are 0.54 and 0.98
- As a quick ratio of greater than 1.0 is required to ensure enough cash on hand to keep your business going, both these years show a potential cash flow problem caused by too much inventory.
- Good management would move to turn inventory over quicker.
- Working Capital is the life blood of your company. Having positive working capital lets your business grow by having in hand sufficient money to buy for growth.
- Working Capital = Current Assets less Current Liabilities
- In our example Year one is +255,250 and Year two as +567,750
- As both years are positive our company has sufficient liquid assets to fund growth.
- If your working capital slips into the negative, with liabilities greater than current assets, you will be in deep trouble.
- Watch working capital carefully.
There are of course many more ratios that can be applied when you’re reading a balance sheet and if your accountant can convince you that you need more, then humour him or her and say, Yes Please.
With the use of current and quick ratios plus a check on your working capital, you will have all you need to keep you well informed and your business growing.
Use your management accountants correctly and you’ll have a business balance sheet prepared every month.
Learn to understand it and then apply your ratios to check your moving in the right direction.
To keep your business growing in the right way … Spend time reading a balance sheet, it will tell you all you need to know.