Do you truly understand what your Balance Sheet tells about your business? Your Balance Sheet is one of the most important financial reports that measures the health of your company and helps you make some crucial business decisions. Knowing how to read it and what exactly each component means is essential for every business owner. In this article, we will guide you through your Balance Sheet and explain what it shows you.
What is a Balance Sheet?
Before we can get into each component and their meaning in your Balance Sheet, let’s define what it is.
Balance Sheet is a financial report that provides insight into a business and it’s operations. It’s essentially a snapshot of your company’s accounts at a single point in time. It covers liabilities, assets and shareholder’s equity.
This is also the document that you give to potential investors, buyers or banks before securing a loan, so they can have a look at how your business is doing. Because the Balance Sheet includes every transaction since the start of your company, it allows them to easily get an idea about its overall financial health.
The Balance Sheet can be prepared and updated once you complete your bookkeeping for a certain period of time. It’s most often used along with the Cash Flow statement and the P&L (Profit and Loss) statement.
What does my Balance Sheet show?
There are quite a few different things that your Balance Sheet can tell you about a business. It also gives you the foundation for further calculations and insights into your finances. Here are the most important things you can find out using a Balance Sheet:
1. Measure the net worth of your business
As mentioned above, Balance Sheet is made up of your assets and liabilities, so you can work out your net worth. The net worth is essentially the owner’s interest in the business. In other words, if your business was to be wound up this is how much you’d be left with as the owner of the business.The net worth formula is:
Net worth = total assets – total liabilities
You’ll notice that there are also different types of assets and liabilities in your Balance Sheet. It is important to know what each stands for.
- Current assets are assets that could be easily converted into cash (or expected to within 12 months). These can include money in transit, money owed to you by customers (accounts receivable), inventory, prepaid expenses, short-term investments and so on.
- Non-current assets can also be called long-term assets, meaning that they aren’t expected to be converted into cash within the next 12 months. These could be buildings, land, machinery, equipment, long-term investments, etc.
- Current liabilities are what your business owes to others and are due within 12 months. These can be money that you owe suppliers (accounts payable), wages you owe to your employees, owed taxes and so on.
- Non-current liabilities are liabilities that are long-term and not due within a year. For instance, long-term loans or bonds that your company has issued.
2. See if your business is solvent
Solvency is the ultimate requirement for survival. If your company is insolvent, it means that it’s not able to pay its debts when they are due. There are two main components to checking solvency with a Balance Sheet:
- Positive net assets – an easy way to see if your business is solvent is by checking if your company’s assets are a larger amount than your liabilities. So, you should get a positive number with the formula (total assets – total liabilities) to be solvent.
- Current ratio – this is also a commonly used calculation for solvency. The formula is (current assets / current liabilities) and your answer should be greater than 1.If you find that your business is insolvent, this means that you won’t be able to pay your bills on time and your company is at high risk of failure. In this situation, you should immediately seek help.
3. Track the strength of your business
To check the strength of your business, you can compare your Balance Sheet to previous periods and track any changes over time. Did your net worth increase or decrease since last year? Has it been steadily increasing for the last 5 years?
The stronger your Balance Sheet is, the more secure you will feel upon a downturn, such as the economic crisis caused by the Coronavirus pandemic. You shouldn’t just look at the situation either – if you spot an issue, you can take action to strengthen your situation and ensure that your business will survive anything it gets thrown at it.
4. Calculate key ratios
Ratios are different calculation formulas used to gain further insights into your business’s situation. They allow you to compare your results year on year or against industry benchmarks and they highlight any areas for improvement.
For instance, you can calculate debtor days which shows you how long on average it takes your customers to pay you. If that number is way too big (and above the number of days stated in your payment terms), then you have to take action to reduce your debtor days.
Or, perhaps, you want to calculate how long it takes your business to sell inventory. You may find out that a specific product is taking a lot longer to sell than others, which may indicate that you should discontinue it.
Key ratios, calculated using your Balance Sheet, will tell you a multitude of things about your company and will help you make some important business decisions.
Article by asfo
