Understanding the Balance Sheet is important to monitor the financials of a business, providing a snapshot of financial data. Its equation goes:
Assets = Liabilities + Stockholder's Equity;
or, alternatively:
Assets - Liabilities = Stockholder’s Equity,
where assets are what one owns, liabilities are what one owes, and stockholder's equity pertains to paper worth.
Assets
Cash, falling under assets, is the most important number in the business – without cash, there is no business. On analyzing Cash, the following are salient:
· How much cash to keep on hand: The typical benchmark is six to 12 months of expenses worth of cash on hand. Factors that may affect this include volatility of the industry, volatility of the company, and capital costs of the business.
· What to do with excess cash: This is a problem, albeit a good one. Reinvesting in the company is an option, but what about when you can no longer reinvest it? Having a plan is important.
· Cash Runway: This is key for startups or cash-poor companies. How long does the business have until it runs out of cash? This is denoted as:
Cash Runway = Total Cash Reserve / Burn Rate, where
Burn Rate = (Cash Balance Beginning of Period – Cash Balance End of Period) / # of Months in Period.
After understanding cash, the next most important is understanding short-term obligations and the business' ability to pay them. Some helpful ratios to understand this are:
· Quick Ratio: This measures your ability to meet your short-term obligations with your most liquid assets and is computed as:
Quick Ratio = Current Assets – Inventory / Current Liabilities.
A higher Quick Ratio suggests better liquidity and financial health.
· Current Ratio: This measures your ability to pay obligations due within one year and is computed as:
Current/Working Capital Ratio = Current Assets / Current Liabilities.
A Current Ratio maintained above 1 is healthy, but too high means capital is used inefficiently.
Another question that arises is whether the business has enough cash to fund growth. Growth is great, but it is also expensive. Having a cash forecast helps understand if there is sufficient cash to support growth. Being able to predict cash balance out into the future will improve business decisions.
Also found under assets is Accounts Receivable, for entities that owe money to the business, representing sales invoiced for but not yet paid. Run an Accounts Receivable Aging and reach out to any invoices over 30 days old. The sooner you contact someone, the more likely you are to get paid.
On the flipside, when it comes to buying decisions, understanding inventory management, particularly what is "too much" or "too little" is necessary. Bad inventory management can kill a company fast. In studying inventory, pay attention to what assets were bought – when buying long-term assets, they will show up in the Non-Current Assets section of your Balance Sheet. Purchasing assets require money or debt. Knowing what assets are purchased helps you better understand your cash outflow and future commitments.
Liabilities
Liabilities represent how much money is owed.
These are classified under Current and Non-Current Liabilities, with Current Liabilities falling due within the year, and Non-Current Liabilities are due in more than one year.
Paying timely on Current Liabilities and understanding Non-Current Liabilities or debt load helps manage the business' cash. Too much debt, or leverage, can be disastrous. To evaluate leverage, use the equation:
Debt-to-equity Ratio = Debt / Equity.
A debt-to-equity ratio of less than 1 is considered safe, whereas a ratio greater than 2 gets risky. Watch your monthly trends and look to industry average to compare.
Stockholder's Equity
A company's book value is the balance of Stockholder’s Equity.
Negative book value means the business are technically insolvent. Though book value does not equate to sale value, the book value's rise or fall can tell you a lot about the health of the company.
It is important to contemplate the business' capital needs: Is it growing? Is inventory needed? Is more equipment needed? All of these things require capital. These are typically funded through:
· Loans
· Cash from profits
· Cash from collecting receivables
· Owner contributions
On making these decisions, stockholders want to know their return on investment. When funding a company, you want returns greater than the alternatives such as real estate or the stock market. Return on investment, or equity, is denoted as:
Return on Equity = Net Income / Shareholder’s Equity.
Ideally, you should be generating 15-20% or more return on equity.
In studying the Balance Sheet, however, one period by itself is only part of the picture. You always want to look at trends to get a feel for how the company is changing. Look at the last period, but also the same time period from the last one to three years. Looking at any statement alone will not give you a full picture.
In a nutshell, these are the 12 things to determine in looking at the Balance Sheet:
· Can we pay current obligations?
· Current vs last period/year?
· What assets did I buy?
· Can we fund growth?
· How much do I owe?
· What's our leverage?
· What is inventory?
· How much cash?
· Who owes me?
· Capital needs?
· What is ROE?
· Book value?