Learning From the Balance Sheet
Most small businesses look at the Profit and Loss Statement regularly, but many don’t understand the importance of the balance sheet.
The balance sheet often lives in the shadow of its better-known brother, the income statement.
While the income statement portrays operating performance, the asset and liability metrics found in the balance sheet provide a picture of the financial health of your business at a given moment in time — usually the end of a month or financial year. It can tell you if you owe more money than what you have on hand, the current value of your assets and the overall value of your business.
More importantly, the balance sheet can provide warning signs so you can solve any problems before they destroy your business! Many business owners don't leverage the information their balance sheet provides. I can help.
Ratios: Using Balance Sheet Data to Determine the Financial Health of a Business
The primary ratios utilizing numbers from the Balance Sheet fall into two broad categories:
financial strength ratios, and
activity ratios.
Financial Strength Ratios: These ratios provide information on how well the company can meet its obligations, how financially stable it is, and how it finances itself.
Current Ratio: This ratio measures a firm’s liquidity – whether it has enough resources (current assets) to pay its current liabilities. It calculates how many dollars in current assets are available for each dollar in short-term debt. A Current Ratio of 2.00, meaning there are $2.00 in current assets available for each $1.00 of short-term debt, is generally considered acceptable. The greater the ratio, the better.
A Current Ratio that is less than the industry average can indicate a liquidity issue (not enough current assets). If the Current Ratio is greater than the industry average, it may suggest that the firm is not using their funds efficiently.
Example: ABC's Current Ratios
June 30, 2017 = $11,336,000 (Current Assets) ÷ $4,272,000 (Current Liabilities) = 2.65
June 30, 2018 = $8,479,000 (Current Assets) ÷ $8,063,000 (Current Liabilities) = 1.05
As you can see, ABC’s liquidity decreased significantly between 2017 and 2018. Its June 30, 2018 ratio is well below the 2.00 “acceptable” ratio.
Working Capital Ratio: This ratio represents operating liquidity. It is similar to the Current Ratio, but looks at the actual number of dollars available to pay off current liabilities. Like the Current Ratio, it provides an indication of the company’s ability to meet its current debt. The higher the result, the better. A negative result would indicate that the company does not have enough assets to pay short-term debt.
Example: ABC's Working Capital (WC)
June 30, 2017 = $11,336,000 (Current Assets) - $4,272,000 (Current Liabilities) = $7,064,000 WC
June 30, 2018 = $8,479,000 (Current Assets) - $8,063,000 (Current Liabilities) = $416,000 WC
There is a significant decrease in working capital between 2017 and 2018. ABC does have more current assets than current liability, but not by much.
Quick Ratio: Similar to the Current Ratio, the Quick Ratio provides a more conservative view as Inventories (generally part of Current Assets) are excluded in the calculation under the assumption that inventory cannot be turned into cash quickly.
If the ratio is 1 or higher, the company has enough cash and liquid assets to cover its short-term debt obligations.
Example: ABC's Quick Ratio
June 30, 2017 = $11,336,000 (Current Assets) - $0 (Inventory) = $11,336,000 ÷ $4,272,000 (Current Liabilities) = 2.65
June 30, 2018 = $8,479,000 (Current Assets) - $0 (Inventory)= $8,479,000 ÷ $8,063,000 (Current Liabilities) = 1.05
ABC's Quick Ratio has definitely deteriorated and is now barely acceptable at just over 1 .
Debt to Equity (Leverage) Ratio: The Debt to Equity ratio measures the company's financial leverage. It provides an indication of how the company finances its assets.
A high result indicates that a company is financing a large percentage of its assets with debt, not a good thing. The lower the ratio, the better. However, understanding the proper ratio for YOUR business is critical.
Example: ABC's Debt to Equity Ratios
June 30, 2017 = $4,768,000 (Total Liabilities) ÷ $7,995,000 (Total Equity) = .596 (a good ratio)
June 30, 2018 = $9,850,000 (Total Liabilities) ÷ $10,837,000 (Total Equity) = .908
The 2018 ratio is still within “acceptable” limits, but the situation appears to be deteriorating.
Activity Ratios: These focus primarily on current accounts, measuring a firm’s ability to convert non-cash assets into cash, providing insight into its operational efficiency. Activity Ratios include numbers from the Income Statement, as well as the Balance Sheet. Since the Balance Sheet is the only financial statement providing a financial “snapshot” at a particular point in time, it is more accurate to use an “average” of the Balance Sheet data when calculating these ratios. The average is generally determined by taking the Balance Sheet results from two consecutive years and dividing by two.
The Balance Sheet is an important source of information for the credit manager. It is universally available for all U.S. public corporations, but may be difficult to obtain from private firms. Ratios are tools to use to evaluate the balance sheet. This in addition to a basic understanding of where the numbers come from can help you run your business efficiently.
The numbers have little value, however, unless they are compared to:
an industry benchmark, and/or
balance sheets for the same company in previous years – so you can determine if there is a trend in one direction or another.
In the case of our sample ABC Corporation, the Balance Sheet data and ratios show the company may be deteriorating.
I could turn the situation around if I am brought in early enough. Don't wait until it's too late to ask for help.