Even though income statements are the ones which attract the investors’ attentions, the balance sheet is still the starting point for understanding a firm’s financial position. The balance sheet shows your company’s assets, liabilities and how much equity owners have for a certain duration of time. Here are crucial points that you should look into when reading a balance sheet.
Liquidity & Solvency
Whenever you are looking at a balance sheet, make sure you look into a company’s liquidity and solvency. Liquidity is the firm’s capacity to meet short term obligations like debt obligations and working capital needs. Solvency, on the other hand, is the measure of a firm’s ability to sustain operations over longer periods of time.
Check out the ratio for a firm’s current assets in comparison to its liabilities, also known as current ratio. Current assets will include securities, equivalents, accounts receivable, inventory and other assets that are convertible to cash. Liabilities are the ones which the firm needs to pay off on the coming year. Most banks would love to see a ratio of 2:1 for small businesses- that is the company should have twice as much its liabilities. Solvency involves the level of debt relative to its equity. You would want to see some balance and this may vary from one industry to another.
Tangible vs. Intangible Assets
When reviewing a balance sheet, determine whether the assets are tangible or not. Tangible assets include buildings, inventory, accounts receivable and equipment. Intangible assets are like trademarks and patents—you need to carefully assess each to determine their real value.
Common Size Analysis
One of the best ways for you to get an overall feel of the balance sheet is to divide it in percentages or perform the common size analysis. A vertical common size analysis deals with liabilities, assets and equity as a certain percentage of the total assets. Take a look at these percentages for about three years to find changes. You can also perform a horizontal common size analysis where you calculate the annual change for each line item on the income statement and balance sheet. Don’t forget to look at receivables. If they are increasing at a higher rate compared to revenue, this is a sign that the firm has an issue with collections.
Key Ratios
The balance sheet will also show you how well a business is managing its receivables and inventory. Here are a few crucial ratios that you need to keep in mind:
- Receivables turnover which refers to sales divided by the receivables
- Inventory turnover which refers to the cost of goods divided by the inventory average
- Total asset turnover which refers to the total sales divided by asset costs
Confusing Points
Financial laymen are usually tripped up when expenses or revenue occur at a different time than the cash paid/received. And when this happens, a firm faces a deferred liability of asset. For instance, what you pay the IRS often differs from the income tax expense for financial reports. If the amount you remit to IRS is more than the tax expense on the income statement, you can record this deferred tax asset on the balance sheet.
Though the balance sheet is meant to be a gateway to determining a firm’s financial position, there are still a lot of nooks for crucial information to hide. Update your company’s balance sheet regularly, encourage the team to study it, and review balance sheets of companies whom your company forges a partnership with.
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