How to Read a Balance Sheet
This article will be of interest to you if you want to really know what your business looks like to a banker or investor, if you want to increase your financial knowledge, or if you want to increase your business wealth.
Phil’s Profit Points™ in Brief:
There are five levels of balance sheet analysis.
Level one: What is your cash position?
Level two: What is your working capital position?
Level three: What is your financing structure?
Level four: What is your value?
Level five: What are the trends?
Let’s continue the story from the last issue that looked at how to analyze your income statement. This week, let’s look at your balance sheet.
The balance sheet presents a snap shot of what you own – the assets – and what you owe – the liabilities – at a specific point in time. This is different from the income statement, which shows performance for a month or some other period of time.
Most entrepreneurs are intimately familiar with their income statements. However, did you know that bankers and investors are more concerned with your balance sheet? That’s because the balance sheet presents the overall health of your company. It incorporates cash flow and asset management analysis with the profits accrued on your income statement.
Analyzing your balance sheet and income statement together, which we’ll discuss in the future, will provide you with a powerful and effective way to ensure that your business is heading in the right direction.
A good balance sheet, one that you receive by the tenth or fifteenth of the month, does several things:
It tells the story of whether your cash is going up or down.
It identifies the good, improving, declining and poor results in terms of working capital items such as cash, accounts receivable, inventory, work in progress, and accounts payable.
It shows whether customers are taking longer to pay you.
It allows you to analyze the value of your company every month.
Level one: What is your cash position?z
At the very least, your balance sheet should show your cash position. Unfortunately, this requires the bank reconciliation to be completed. With online banking information available immediately, this function should be completed within a couple days of month end (at the latest).
Is cash increasing or decreasing, and why?
Are you using short-term cash to fund the purchase of long-term assets?
Are you effectively using excess cash?
Level two: What is your working capital position?
Working capital includes items that will convert to or utilize cash in the next twelve months.
Are accounts receivable increasing or decreasing, and why?
Are inventories and work in progress increasing or decreasing, and why?
Are accounts payable increasing or decreasing, and why?
Level three: What is your financing structure?
There is good debt and there is bad debt. Good debt lets you borrow money at low interest rates and turn that money into profits, thus increasing the value of your business, and your wealth.
Are you borrowing appropriately by matching working capital needs to an operating line of credit?
Are you using short-term cash to fund long-term asset acquisitions such as equipment or vehicles (this isn’t a good idea, unless you have lots of cash)?
Is your debt to equity ratio less than 2.0:1.0 and preferably much less (unless you are a start-up, then all bets are off).
Level four: What is your value?
The balance sheet presents the value of your business in the equity section as retained earnings. This is also called book value because it is based on the accounting concept of historical cost where all of your assets, liabilities, revenues and expenses are recorded at their actual cost. If you bought your building twenty years ago, and it appreciated in value, then your book value will be artificially low.
Is your retained earnings, which is the accumulation of your profits less dividends paid out, growing?
If you need to borrow money or want to sell your company, aggressive tax minimization practices that reduce your profits and retained earnings can hurt your valuation in the eyes of a lender or investor. Is your equity sufficient to attract capital or investors?
What is your plan to convert your retained earnings into personal cash and wealth?
Level five: What are the trends?
Most accounting software will print a ‘comparable balance sheet’ which shows the account balances for the current period and the same period one year ago.
What are the major dollar variances between accounts?
Do these changes make sense given your recent business performance and market trends?
Proportionately, is your business stronger and healthier than a year ago?
Tough Question
Are you using your balance sheet to help you evaluate your company’s performance like an investor or banker would?
From the Piggy Bank
Your balance sheet says more about your company and management than your income statement.
Have a profitable week!
