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Apr 29, 2011 - 4 minute read - Comments - business planning

Know Your Financial Statements - Part One: The Balance Sheet

Many small business owners know next to nothing about their financial statements. So what? Why is that a problem? Financial statements can tell you a lot about your business. To the right reader, they communicate the health, strengths and weaknesses of the business. They also go a long way in determining the value of the firm. Whether you are selling, buying, financing or operating a business, learning the language of financial statements is a must for any good manager.

A look at your financial statements can shed light on the health of your business.

This blog post will give the basics of the balance sheet. The balance sheet is a snapshot of the business. It shows:

  • The size of the business
  • The financial structure of the business
  • The short-term health of the business
  • A partial look at the riskiness of investing in the business

These are all useful things to know. The first side of the balance sheet includes a listing of assets. Essentially, an asset is anything that the company owns that could be sold for cash. There are two types of assets: Current and Fixed.

Current Assets These include anything that is expected to be turned into cash within the year. Things typically listed are:

  • Cash - Your bank balance.
  • Accounts Receivable - Outstanding invoices owed to you by your customers.
  • Inventory - Anything that you have bought or made and have not yet sold.

These assets are listed in their preference. Cash is king because you have it. Accounts receivable are next because the product is sold and delivered. Inventory is the least desirable because it isn’t sold yet and can get stolen, go obsolete or get ruined.

Fixed Assets The other type of asset is fixed. They include your land, buildings, equipment and other things that are needed to produce sales, but are harder to turn into cash in a hurry. You will often see a line titled “Less Depreciated Assets” right under your capital equipment. This is due to our system of accrual accounting. It assumes that each year, a portion of your infrastructure gets used up. This is meant to spread the cost of the fixed assets over several years. On the other side of the balance sheet are two categories: Liabilities and Equity. Liabilities, like assets are classified as current or long term.

Current Liabilities These include anything expected to be paid within the next year. They include

  • Accounts Payable - What you owe your suppliers.
  • Short Term Debt - Debt that is intended to be repaid in a short period. Lines of credit balances show up here.
  • Current Maturities of Long Term Debt - The principal payments due in the upcoming year.

One important measure to note here is the current ratio. This is the ratio of current assets to current liabilities. The ratio should be higher than 1, meaning that the business could raise enough cash quickly to settle the current accounts if need be. If this is below 1, you could have trouble meeting your payments.

Long Term Liabilities This usually includes the portions of debt that won’t be paid in the next year.

Equity When you subtract the liabilities from the assets, the remainder is equity. This has two components. The first is paid-in equity. This is the investment made by the owner(s) of the company. The second is retained earnings. Retained earnings are the accumulated net profits of the company minus any dividend payments made to the owners. A good way to check the riskiness of your business is to compare your debt to equity ratio. The higher the ratio, the riskier the business. This is due to the fact that bank will get paid their interest and principal, regardless of how well the business performs. When times are good, the owners do extremely well, because they keep everything beyond their debt obligations. But, if the business does poorly, the owners get hit harder because the bank will get their money, one way or another. This concept is called financial leverage. So there are some of the basics of the balance sheet. Next week we’ll cover the income statement and the cash flow statement. Have a great weekend!