Understanding the Balance Sheet
Many business owners may not understand the importance of the Balance sheet. Balance Sheet provides current health status of the business. In conjunction with Statement of Cash Flows and Income Statement, It may present early signs of downward tail-spin if compared with previous Balance Sheets, and give a company a fighting chance to take action before its too late. If you are a shareholder of a company or its owner, it is essential that you understand how the balance sheet is structured, how to analyze it, and how to read it. The reason banks will ask for Balance Sheet is to look for the same red flag signs before approving any loans.
The good thing that you are reading this article and you are ready to learn.
In simple words, the Balance Sheet is a bird-eye view of the business's financial state at this moment. Its best practice to compare your Balance Sheets with previous months, of prior seasons (if its seasonal business) to understand which direction your business is moving.
Here are three components that make up the Balance Sheet:
ASSETS - these are things of value that your business owns. Assets categorized by how fast it can be converted into cash if needed. To clarify It splits into two sections:
- "Cash in One Year," like cash, inventory, vehicles, digital assets
- "Long Term" like equipment, land, other investments
LIABILITY - these are things that your business owes, like bank loans, line-of-credit, rent, wages.
SHAREHOLDER EQUITY - it's the money business controls. EQUITY categorized into three categories
- Contributed Capital - money landed to business by people (usually owners)
- Retained Earnings - profits from doing business
- Treasury Stocks - its share of the company that is not yet owned by anybody, and can be sold later to raise money
To summarize this, the balance sheet formula is ASSET = LIABILITY + EQUITY
Now, as we understand what the Balance Sheet is, let's discuss how the Balance Sheet can help us. Three essential things that we can take away is Liquidity, Safety, and Risk.
LIQUIDY - In simple: how well you can pay your bills on time.
You can calculate the liquidity ratio by taking current asses and divide them by current liability. The higher the current ratio is, the more your business can pay off any short-term debts. Companies with low liquidity get into trouble quickly, and it should be a trigger for you to take action by making more efficient processes or look for additional streams of revenue.
SAFETY MARGIN - (one of the most favorite ratios by bankers) the total number of sales dollars that can be lost before the company loses money.
Everything measured from BEP (Breaking Point). BEP is right exactly what it sounds. It's a point where you don't make a profit or take a loss. Negative Safety Margin may occur if your sales fall below the break-even point
The formula to calculate Safety Margin is Sales - Break-even sales.
RISK - Debt to Equity Ratio. This factor tells you how significant is your chance to default on paying off your current debts in event company closes its doors. For most businesses, a healthy range for debt to equity ratio is between 1 and 1.5. However, the ideal debt to equity ratio will vary depending on the industry. The higher the debt to equity ratio, the higher the risk.
The formula to calculate the Debt to Equity ratio (d/e) is Total Liabilities / Equity.
The Balance Sheet, together with the Income Statement and Cash Flow Statement, make up the cornerstone of any company's financial statements.