Understanding the Balance Sheet

As a business advisor, I have assisted business owners to gain a better understanding of financial statements. They typically wanted to know how to make better us of the information contained on their balances sheet.

A good balance sheet can reveal subtle trends of increasing debt, inventory control problems, and cash flow problems. Additionally a balance sheet is required when seeking a business loan approval and used in determining the value of your business. Owners need to be aware of their current payable balances due and the current assets available to cover those bills. Lenders look at your balance sheet to determine your existing capital structure or the ratio of debt to equity to determine if you can support additional debt.

Balance sheets are a record of your financial status at a specific time. Comparing balance sheets across different times will reveal trends in your business enabling you to take timely corrective actions. Following are a few simple ways to use the balance sheet to understand financial trends of your business.

1. Compare this month to last month: check balances of current asset accounts for cash, accounts receivable, inventory, and current liability accounts for accounts payable, taxes payable, payroll payable. Calculate a Quick Ratio by dividing the total CASH + Accounts Receivable by the total current liabilities. A low Quick Ratio indicates pending trouble in paying your bills. A Quick Ratio greater than 1 to 1 is desirable, indicating sufficient ability to pay your bills.

2. A common problem for small business is cash flow, while the profit and loss statement shows a profit there is no cash in the bank. Common places to look for what happened to the cash are the accounts receivable, inventory. If the amounts in inventory and or accounts receivable are increasing then more of your cash is tied up until inventory is sold or customers pay their bills.

3. Another method for determining how much cash you should hold in the bank is to calculate working capital needs by subtracting total current liabilities from total current assets then divide by sales.

4. Inventory efficiency can be monitored by calculating inventory turnover. Divide cost of goods sold as shown on the profit & loss statement by the value in inventory. If the ratio is 2 then each dollar of inventory worked twice, if the ratio is 6 then each dollar worked much more efficiently at 6 times.

5. In the equity section of a balance sheet the line for Retained Earnings is a track record of your business performance, adjusted for amounts taken out by the owners. Retained earnings also represent the amount of value re-invested in growing the business.

6. Efficiency of your business can be measured in several ways. A ratio measuring sales to assets indicated how hard your assets are working. Low sales to assets ratio may indicate you have too much money tied up in assets. Return on Equity, pretax profits divided by net worth, reports the earning benefit of your investment in the business.