Reading or analyzing your balance sheet may sound a bit intimidating, like it's something stock analysts and bank managers do. I'd like to bring it much closer to you and help you become familiar with it so you can use it as one of your business tools.
Preparing Accurate Financial Statements
To begin, we have to get accurate financial statements for your business. It's not always as easy or as obvious as it sounds. Many small business owners, when they first come to me, complain about not having a correct balance sheet. They had a family member take care of their books and that person had just the very basic knowledge of QuickBooks and knew how to input invoices and pay bills.
In order to prepare accurate financial statements for a business, a bit more accounting knowledge is needed. So, let's make sure we have that first.
Reading a Balance Sheet
Now we can start by understanding its main categories – assets, liabilities and equity. It's really all very logical and intuitive. Assets are simply things your business owns, liabilities are the company's debts and obligations and the equity is the residual value. Your balance sheet must always balance and the equation is:
Assets = Liabilities + Equity
Assets and Liabilities are further divided into short-term and long-term categories. Everything which comes due within 12 months or the operating cycle is considered short-term.
Examples of current (short-term) assets are: cash, marketable securities, accounts receivable and inventory.
Long-term assets can be items such as: property, plant & equipment (land, buildings, equipment and vehicles) and intangible assets (ex. Goodwill and trademarks).
On the liabilities side, we have the current category typically composed of: accounts payable, current portion of long-term debt, unearned revenues, taxes payable and accrued wages.
And here are examples of long-term liabilities: long-term notes payable and bonds payable.
The equity section usually contains the following: common stock, retained earnings and net income for the period. The equity section will be different depending on the legal structure of the business.
Balance Sheet Analysis
If you are looking at only one period, you analyze it vertically, as opposed to comparative analysis when you are looking at two or more periods.
The best way to read and analyze a balance sheet is using ratios, because absolute numbers do not tell the whole story and do not capture the important relationships between the different components of the balance sheet and therefore the business.
Ratios, on the other hand, are like barometers, helping you stay on track and warning you when things start going in the wrong direction.
The most important ratios are:
Current ratio = Current Assets / Current Liabilities
Quick Ratio = Current Assets less Inventory / Current Liabilities
Net Working Capital = Current Assets less Current Liabilities
Debt to Asset Ratio = Total liabilities / Total Assets
Debt to Equity Ratio = Total liabilities / Shareholders Equity