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Understanding the Balance Sheet

Examining the Components and Ratios of a Balance Sheet To Show Business Health

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.

 

Sample Balance Sheet: Acme Manufacturing

Similar to the Income Statement, Acme manufacturing’s Balance sheet (seen below) can be assessed through a variety of ratios and functions. While credit decisions should not be based on the analysis of a balance sheet or income statement alone, it does offer insight to show general business health.

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ASSETS
Current
Cash $160,000
Accounts Receivable $221,400
(less bad debt allowance) $14,400 $207,000
Marketable Securities $37,500
Inventory $158,600
Prepaid Insurance $9,400 $572,500
Long Term (plant, property, equipment)
Land $114,500
Buildings $790,200
 – Depreciation $192,000 $598,200
Equipment $643,800
 – Depreciation $205,000 $438,800 $1,151,500
TOTAL ASSETS $1,724,000

 

LIABILITIES
Current
Accounts Payable $100,500
Accrued Wages Payable $86,800
Income Taxes Payable $93,500 $280,800
Long Term
Mortgage Payable $278,000 $558,800
EQUITY
Common Stock
22,000 Shares Outstanding $220,000
Retained Earnings $945,200 $1,165,200
TOTAL LIABILITIES AND EQUITY $1,724,000

 

 

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 (businesses that will meet financial obligations when due) will have liabilities on their account, a high percentage of liabilities compared to assets or equity can be cause for concern.

Example #1 – Acme Manufacturing’s 2020 Assets

2020
Assets = Shareholders’ Equity + Liabilities $1,165,200 (Shareholders’ Equity) + $558,800 (Liabilities) =
$1,724,000

As you can see, Acme Manufacturing’s 2020 assets are not financed equally. Shareholder’s Equity represents 67.6% of their assets while Liabilities represent 32.4% of their assets. This is one sign of a generally healthy business.

[Balance Sheet]

 

Assets

Assets represent the resources that a business owns or controls at a given point in time. There are two main types of assets:

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 Acme Manufacturing’s current assets are primarily Accounts Receivable and Inventory ($207,000 + $158,000 = 21.2% of current assets) rather than Cash & Cash Equivalents ($160,000 + $37,500 = 11.5% of current assets).

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

 

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 #2: Total Liabilities listed for Acme Manufacturing is almost evenly split, with current liabilities representing 50.3% and long term liabilities representing 49.7%.

 

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:

  1. Paid-in capital: the dollar amount shareholders/owners paid when the stock was first offered.
  2. 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

  1. 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.
  2. 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 – Acme manufacturing’s Current Ratio

2020
Current Assets = Current Assets ÷ Current Liabilities $572,500 (Current Assets) ÷ $280,800 (Current Liabilities) =
$2.04

As you can see, Acme Manufacturing’s liquidity shows over $2.00 available in current assets for every dollar of short term debt – this is acceptable.

[Balance Sheet]

 

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 – Acme Manufacturing’s Working Capital (WC)

2020
Working Capital (WC) = Current Assets – Current Liabilities $572,500 (Current Assets) – $280, 800 (Current Liabilities) =
$291,700

Acme Manufacturing’s Working capital is positive, representing a larger dollar value than their current liabilities.

[Balance Sheet]

 

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 – Acme Manufacturing’s Quick Ratio

2020
Quick Ratio = (Current Assets – Inventories) ÷ Current Liabilities ($572,500 (Current Assets) – $158,600 (Inventories)) ÷ $280,800 (Current Liabilities) =
$1.47

With a more conservative view at Acme Manufacturing’s operating liquidity, there is definitely enough cash and liquid assets to cover short term debts.

[Balance Sheet]

 

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 – Acme Manufacturing’s Debt to Equity Ratio

2020
Debt to Equity (Leverage) Ratio = Total Liabilities ÷ Total Equity $558,800 (Total Liabilities) ÷ $1,165,200 (Total Equity) =
$0.48

Acme Manufacturing shows a very good Debt to Equity ratio.

[Balance Sheet]

 

 

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 Acme Manufacturing’s Balance Sheet, it appears that their financial health is in good standing. However, it would make sense to obtain the previous year’s Balance Sheet to compare any trends that should be addressed in the next fiscal year. It would also bee helpful to read the Notes to Consolidated Financial Statements included in the 10-Ks supplied to the U.S. Securities and Exchange Commission.