How to read business’s financial statements (Balance Sheet)

A business’s Balance Sheet, also known as the ‘Statement of Financial Position’ reveals a business’s net worth. The Balance Sheet, together with Profit and Loss Statement and Cashflow Statement make up the crucial elements of the financial statements. 

There are four important components of a balance sheet. 

1. Assets
2. Liabilities
3. Equities
4. Financial Ratios

Assets

These are resources and items owned by the company. They include short term (current) and long term (non-current) assets.

• Current assets represent cash, debtors, and prepaid expenses. These assets are part of a business’s daily operations. 
• Non-current assets range from buildings, machines, land, stock, and equipment. The numbers should represent what these assets are worth in case the business must sell these assets. 

Liabilities

These are debts and amounts owed and include creditors and suppliers, taxes, loans, and interest payments. 

Equities

Equity represents monies that have been invested by the owners and other shareholders as well as profit (retained earnings) that have been accumulated and put into the business. 

Financial Ratios

These are calculations used to determine the health of the business and allows stakeholders to determine if management is using the assets profitability as well as its sustainability and viability. The most common ratios are Return on Assets, Current Ratio and Debtor Days. These are explained below.  

When analysing the balance sheet, it is important to compare it to previous years or to similar industries.

What to look out for on a balance sheet?

Ratio: Inventory Turnover 

• A growing and high inventory number should only occur when you are expanding. However, if the business is not growing and inventory is increasing, it could mean products are not selling or there are many returns. This may result in the inventory being obsolete and valued less. Excess inventory also requires additional costs to store and insure. 
• On the opposite side, insufficient inventory could represent loss of sales due to not fulfilling demand. The business may require paying an excess to replenish inventory which reduces its efficiency. 
• This is where the inventory turnover ratio is crucial. An inventory turnover of 4-6 is considered a good ratio. A low ratio means certain products are not selling. A high turnover is generally good but needs to be carefully monitored in case of stockouts. 

Ratio: Accounts Receivable / Debtor days

• A large debtor balance is only good if it can be quickly converted to cash. If a customer takes longer to pay their invoices, this should raise a red flag that their business is in trouble and there is a risk of them defaulting. 
• This ratio should be compared to the payment terms. If it is longer, than it may indicate the business is struggling to collect money from sales. It also could indicate that payment terms are too generous.

Ratio: Return on Assets

• This provides a general ratio of sales that are being generated with regards to the assets they have. If the number is high (compared to previous years or other industries) then it indicates the assets are being well utilised. Generally, anything over 5% is considered good. 
• The example calculation of the ratio is per below. It is above the 5% benchmark and increasing compared to prior year, so the business is using its assets efficiently and effectively.

Ratio: Current Ratio

• Cash flow is always a significant problem for many businesses. In a situation where cash in urgently required, the business may need to sell its assets to convert to cash. The current ratio measures a business’s ability to pay off short-term debts. 
• A good current ratio is between 1.2 to 2, which means the business can sell its current assets and cover all its immediate liabilities. A current ratio below 1 means a business does not have enough liquid assets to cover its short-term debts.

A Balance Sheet, along with other financial statements, is an important tool to gain insight into a business and its operations. Analysis should be combined with benchmarking of competitors or similar businesses. This will determine whether the business is operating as efficiently and effectively compared to industry standard.

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Disclaimer

This article is provided with the compliments of Alan Dinnie. It is genuinely intended to offer readers information to make better decisions and to give insight into various aspects of business in general, and more particularly related to the sale and purchase and management of businesses. 

All material presented herein is intended for informational purposes only. Information is compiled from sources deemed reliable but may be subject to errors and omissions. No statement is made as to the accuracy of any description. Alan Dinnie makes no warranties or representations regarding the information and excludes any liability which may arise because of the use of this information. This information is the copyright of Alan Dinnie.

Nothing herein shall be construed as legal, accounting, or other professional advice outside the realm of real estate and business brokerage. 

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To your business success