The balance sheet gives analysts a snapshot of the financial health of any small business. While the profit and loss statement is important to see the activity during a particular year, the balance sheet gives a better indication of whether the company has the necessary assets to survive in today’s unpredictable economy. Learning how to read the balance sheet will help you analyze the health of your small business or that of another company you wish to acquire.
Interpreting the balance sheet: Basic accounting equation
The basic accounting equation is assets equal liabilities plus equity. Assets are everything the company owns, including cash and customer accounts that have not been collected upon. Liabilities are debts owed by the company. Equity is the amount of money that has been invested in the company, including the retained earnings from prior years.
Interpreting the balance sheet: Current assets and liabilities
A current asset or liability is anything that will be turned into cash in the next year. For example, inventory and accounts receivable are considered current assets because they can be reasonably expected to turn over during the next 12 month period. Current liabilities are those bills that are expected to be paid during the next 12 months. Other liabilities like bank loans are generally categorized as long-term liabilities on the balance sheet. The balance sheet lists assets and liabilities in order of liquidity. The first asset listed will always be cash, followed by accounts receivable and inventory. Long-term assets like fixed assets and investments in stock or bonds are listed last because they are very difficult to turn back into cash.
Interpreting the balance sheet: Financial ratios
Business analysts use a set of financial ratios to determine the health of a company. The first place to look when reading a balance sheet is at the current ratio, or current assets divided by current liabilities. If the ratio is greater than one, then the company has adequate current assets to handle all of their expected liabilities in the next 12 months. The debt-to-equity ratio is the company’s total balance sheet liabilities (both current and long-term) divided by the company’s total equity. This ratio indicates how much of the company’s equity was acquired from outside lending sources. If the debt-to-equity ratio is higher than one, the company may have too much debt for its current level of equity. To calculate these ratios, you can also use accounting software like ticket management software. Ticket management software makes it simple for you to do all the transactions automatically.
Interpreting the balance sheet: Compare several years
A single year’s financial ratios can only give you a limited part of the overall picture of a company’s health. It is best to compare the current and debt-to-equity ratios from year to year to see if the company is becoming more or less stable. Even without looking at an income statement, it is possible to get a good idea of a company’s financial position just by analyzing a few years worth of balance sheets.