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Understanding the Balance Sheet

Originally Published: February 2010

by Christine Newhouse
Director Accounting, ABC-Amega Inc.

Assets = Shareholders’ Equity + Liabilities

The equation above represents the primary components of the balance sheet, an integral part of a company’s financial statements.

The balance sheet highlights the financial position of a company at a particular point in time (generally the last day of its fiscal year). This financial statement is so named simply because the two sides of the Balance Sheet (Total Assets and Total Shareholder’s Equity and Liabilities) must balance.

Of the three primary financial statements – Balance Sheet, Income Statement, and Statement of Cash Flows – the Balance Sheet is the only one that provides data at a single point in time, rather than over a defined time period.

Components of the Balance Sheet and What They Can Tell Us

By looking at the Balance Sheet equation, you can determine how the company has financed its assets. They have two options: by borrowing (liabilities) and by using the shareholders’ investment (equity). While most going concerns will have liabilities on their account, a high percentage of liabilities compared to assets or equity can be cause for concern.

Example #1 - XYZ's 2009 Balance Sheet Information

Balance Sheet Equation: Assets = Shareholders' Equity + Liabilities 
$20,687,000 (Assets) =
$10,837,000 (Equity) +
($8,063,000 + $1,787,000) = $9,850,000 (Liabilities) 
$10,837,000 (Equity) + $9,850,000 (Liabilities) 
$20,687 (Assets) = $20,687 (Equity and Liabilities) 

As you can see, XYZ’s May 31, 2009 assets are financed almost equally between Shareholder’s Equity (52%) and Liabilities (48%).
 

ASSETS

Assets represent the resources that a business owns or controls at a given point in time.

There are two main types of assets:
  1. Current Assets: 
  • Cash
  • Cash Equivalents – assets/investments that are "liquid" (easily converted into cash), including money market holdings, short-term government bonds or Treasury bills, marketable securities, etc. These are current assets if they mature within 3 months and have no significant risk of a change in value. Common stock, therefore, cannot be considered a cash equivalent, but preferred stock, acquired shortly before its redemption date, can be.
  • Inventory
  • Accounts (Trade) Receivables – these are classified as a current asset if they are due within one year or less.
  • Prepaid Expenses – money paid for future services that will be used within a year.

When a large amount of cash is recorded on the balance sheet, it's generally a good sign as it offers protection during business slow-downs and provides options for future growth.

Growing cash reserves often signal strong company performance; dwindling cash can indicate potential difficulties in paying its debt (liabilities). However, if large cash figures are typical of a company’s balance sheet over time, it could be a red flag that management is too shortsighted to know what to do with the money.

Note #1: You can see that XYZ Corp's current assets in 2009 are made up of primarily Cash & Cash Equivalents ($3,894,000 = 46%) and Trade Receivables ($2,570,000 = 30%).

In 2008, current assets included a large component of Marketable Securities (39%).


    2. Fixed Assets: also known as "non-current assets", “capital assets”, “long-term assets” or “property, plant and equipment” (PP&E). Fixed assets are not quickly or easily converted into cash. These include land, buildings, vehicles, furniture, equipment, fixtures etc. Except for land, these assets are generally depreciated over time.

    Note #2: There was a fairly significant decrease (25%) in current assets between 2008 and 2009, and a large increase in non-current assets (755%) for the same period.

    While the Total Assets position increased by 62% in 2009 over 2008, current assets actually decreased by 25%.

    A comparison of the numbers gives the impression that sales of Marketable Securities in 2008 were used to fund non-current assets.

Liabilities

Liabilities represent what the company owes. 

The two primary types of liabilities are:
  1. Current Liabilities: Obligations the company must pay within a year, including accounts payable, notes payable, accrued expenses, current maturities on long-term debt liabilities.
  2. Long-term Liabilities: Obligations not due within one year, including things like mortgages, bonds, long-term notes payable.

Financially healthy companies generally have a manageable amount of debt (liabilities and equity). If the debt level has been falling over time, that’s a good sign. If the business has more assets than liabilities – also a good sign. However, if liabilities are more than assets, you need to look more closely at the company’s ability to pay its debt obligations.

Note #3: Total Liabilities listed for XYZ more than doubled in 2009 over 2008. Total assets increased by 62%. However, Total Current Assets on May 31, 2009 ($8,479,000) are only slightly more than Total Current Liabilities ($8,063,000).

Note #4: In order to balance Equity and Total Liabilities to assets on May 31, 2009, XYC increased their Intangible Assets and “Goodwill” (also intangible) by more than 1200%! This bears looking into.

Equity

Equity, often called “shareholders equity”, “stockholder’s equity”, or “net worth”, represents what the owners/shareholders own.

Equity is considered a type of liability, as it represents funds owed by the business to the shareholders/owners.

On the balance sheet, Equity = Total Assets - Total Liabilities.

The two most important equity items are:
  • Paid-in capital: the dollar amount shareholders/owners paid when the stock was first offered.
  • Retained earnings: the money (profit) the firm has elected to reinvest in the company.

Using Balance Sheet Data to Determine the Financial Health of a Business

Balance Sheet Ratios

The primary ratios utilizing numbers from the Balance Sheet fall into two broad categories: (1) financial strength ratios, and (2) activity ratios.

Financial Strength Ratios

These ratios provide information on how well the company can meet its obligations, how financially stable it is, and how it finances itself.

Current Ratio = Current Assets ÷ Current Liabilities

This ratio measures a firm’s liquidity – whether it has enough resources (current assets) to pay its current liabilities. It calculates how many dollars in current assets are available for each dollar in short-term debt.

A current ratio of 2.00, meaning there are $2.00 in current assets available for each $1.00 of short-term debt, is generally considered acceptable. The greater the ratio, the better.

A current ratio that is less than the industry average can indicate a liquidity issue (not enough current assets).

If the current ratio is greater than the industry average, it may suggest that the firm is not using its funds efficiently.

Example #2 – XYZ's Current Ratios

May 31, 2008 = $11,336,000 (Current Assets) ÷
 $4,272,000 (Current Liabilities) = 2.65 

May 31, 2009 = $8,479,000 (Current Assets) ÷
 $8,063,000 (Current Liabilities) = 1.05 

As you can see, XYZ’s liquidity decreased significantly between 2008 and 2009. It’s May 31, 2009 ratio is well below the 2.00 “acceptable” ratio. 

Working Capital = Current Assets – Current Liabilities

Working Capital represents operating liquidity.

The Working Capital ratio is similar to the Current Ratio but looks at the actual number of dollars available to pay off current liabilities. Like the current ratio, it provides an indication of the company’s ability to meet its current debt. The higher the result, the better. A negative result would indicate that the company does not have enough assets to pay short-term debt.

Example #3 – XYZ's Working Capital (WC)

May 31, 2008 = $11,336,000 (Current Assets)
 - $4,272,000 (Current Liabilities) = $7,064,000 WC 

May 31, 2009 = $8,479,000 (Current Assets)
 - $8,063,000 (Current Liabilities) = $416,000 WC 

There is a significant decrease in working capital between 2008 and 2009. XYZ does have more current assets than current liability, but not by much. 

Quick Ratio = (Current Assets – Inventories) ÷ Current Liabilities

Similar to the Current Ratio, the Quick Ratio provides a more conservative view as Inventories (generally part of Current Assets) are excluded in the calculation under the assumption that inventory cannot be turned into cash quickly.

If the ratio is 1 or higher, the company has enough cash and liquid assets to cover its short-term debt obligations.

Example #4: -- XYZ Quick Ratio

May 31, 2008 = $11,336,000 (Current Assets) - $0 (Inventory) =
 $11,336,000 ÷ $4,272,000 (Current Liabilities) = 2.65 

May 31, 2009 = $8,479,000 (Current Assets) - $0 (Inventory)=
 $8,479,000 ÷ $8,063,000 (Current Liabilities) = 1.05 

XYZ's Quick Ratio has definitely deteriorated and is now barely acceptable at just 
 over 1. 
Debt to Equity (Leverage) Ratio = Total Liabilities ÷ Total Equity

Also called the "Acid Test", the Debt to Equity ratio measures the ability of the company to use its current assets to retire current liabilities. It provides an indication of how the firm finances its assets.

A high result indicates that a company is financing a large percentage of its assets with debt, not a good thing.

The upper acceptable limit is 2.00 with no more than 1/3 of debt in long-term liabilities. The lower the ratio, the better.

Example #5 – XYZ Debt to Equity Ratios

May 31, 2008 = $4,768,000 (Total Liabilities) ÷
$7,995,000 (Total Equity) = .596 (a good ratio)

May 31, 2009 = $9,850,000 (Total Liabilities) ÷
$10,837,000 (Total Equity) = .908

The 2009 ratio is still within “acceptable” limits, but the situation appears to be deteriorating. 

Activity Ratios

Activity ratios focus primarily on current accounts, measuring a firm’s ability to convert non-cash assets into cash, providing insight into its operational efficiency.

Activity Ratios include numbers from the Income Statement, as well as the Balance Sheet. Since the Balance Sheet is the only financial statement providing a financial “snapshot” at a particular point in time, it is more accurate to use an “average” of the balance sheet data when calculating these ratios. The average is generally determined by taking the Balance Sheet results from two consecutive years and dividing by two.

Activity Ratios will be discussed in a future article.

Other Assets and Liabilities

There are certain classes of assets and debt that are usually not included on a small or medium-sized company’s balance sheet because they are not available for payment of a firm’s debt. These include:

Intangible Assets: Sometimes called Intellectual Property, including goodwill, patents, copyrights, mailing lists, catalogs, trademarks, organization expense.

Long-Term Investments: Including investment in, or advances to subsidiaries, cash surrender value of insurance policies, cash or securities set aside in “special funds”, investment in stocks or bonds for possible capital appreciation.

Miscellaneous Assets: Including receivables from officers or employees and advances to sales people.

Off-balance sheet debt: A form of financing in which large capital expenditures are kept off the balance sheet.

The Balance Sheet is an important source of information for the credit manager. It is universally available for all U.S. public corporations, but may be difficult to obtain from private firms.

The numbers have little value, however, unless they are compared to:
  1. an industry benchmark, and/or
  2. balance sheets for the same company in previous years – so you can determine if there is a trend in one direction or another.

In the case of our sample XYZ Corporation Balance Sheet, it appears that the financial health of XYZ might be deteriorating. Therefore, it would make sense to obtain the 2007 numbers and/or discuss some of your concerns with XYZ directly. You should definitely read the Notes to Consolidated Financial Statements included in the 10-Ks supplied to the U.S. Securities and Exchange Commission.

*****


Christine Newhouse, Director Accounting, ABC-Amega Inc., has been with ABC-Amega for 30 years. She holds a B.S. in Accounting from Canisius College. She is on the Board of Directors of the Western Division Federal Credit Union and is a member of the American Society of Women Accountants.