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  • Writer's pictureP. Seely

The Value of Balance Sheet Analysis

Financial Analysis

Your balance sheet tells an important story. It outlines what your small business owns and owes at a specific point in time. This makes your balance sheet a very powerful tool for documenting your financial standing at a given point in time.

A recent U.S. Small Business Administration report found that only about half of all small businesses survive five years. If you want to avoid being a part of the nearly half that don’t make it, you may want to consider changing your methods. You can start by understanding, using, and documenting your assets on a small business balance sheet by using QuickBooks. All editions of QuickBooks provide company financial statements but oftentimes the account types are used incorrectly. If you don't use QuickBooks you may want to look at other free Balance Sheet templates and examples from Template Lab or built-in templates offered by Microsoft Office.

Investors, stakeholders, creditors, customers, and even your managers can utilize your small business’s balance sheet to help make important decisions that will affect the future financial health of your small business. For instance, investors can look at your balance sheet to see how much debt your small business has. Investors also can see what your business has for cash and what type of funds your company has generated.

These are all key pieces that play into an investor’s decision to invest in your small business. Therefore, a balance sheet that shows favorable information in these categories will attract more support from investors. This can ultimately foster the future growth of your small business.

As a small business owner, it is important to take a step back and look at your operations periodically. Even if everything is going smoothly, looking at your balance sheet can provide insight into where your small business is headed. Key elements of your finances that your balance sheet communicates include:

Your small business’s assets. Your assets include items that you own: cash, equipment, accounts receivable, and even any patents held in your name. A classified balance sheet presents information about an entity's assets, liabilities, and shareholders' equity that is aggregated (or "classified") into subcategories of accounts.

How effectively your small business uses capital.

Here, you’ll want to figure out your small business’s working capital. This involves subtracting the amount of current liabilities from your current assets. The higher the number, the easier your small business can meet its bills and financial obligations. However, when looking at capital on your balance sheet, you should also consider what industry you compete in and how dependable your customers are. After all, dependable customers are important for collecting your accounts receivable, which are assets for your small business. Your small business’s risk of bankruptcy. Balance sheets can show your small business’s risk of not being able to pay its debts by highlighting your liabilities in relation to your cash flows. If you don’t have enough cash flow to pay your debt payments or other liabilities that are due, then you could be in trouble.

Your small business’s ability to grow in the future. One way your balance sheet can show this is by having a high amount of capital. When this is true, you can easily pay your financial obligations and invest in areas that lead to business growth.

The Role of the Balance Sheet in Financial Statements

You may think your balance sheet provides a straightforward approach for outlining your financial standing, and you’d be right. However, it does more than this. It connects with your small business’s income statement and cash flow statement to provide an even deeper look at your finances. Intersections between your balance sheet and your other financial statements include:

Net income.

Your reported net income on your income statement will link into retained earnings on the balance sheet. It also will link into your cash from the operations section of your cash flow statement.

Cash inflows and outflows.

Your cash inflows and outflows that are recorded on your cash flow statement are directly reported on your balance sheet.

How to Perform a Balance Sheet Analysis

After you’ve created your balance sheet, you’re going to want to know how to analyze it. To analyze it properly, be sure to look at every section carefully. This includes your assets, liabilities, and shareholders’ equity. Once you understand what your company has in these categories, you can then use ratios to draw even more conclusions.

Useful ratios include:

Solvency Ratios

These are used to analyze your small business’s cash, assets, and debt. Through these ratios, you are trying to see if your small business has enough cash and assets, coupled with low debt, to continue functioning successfully. The higher the ratio, the more financial strength your small business has.

Solvency ratios include:

Quick Ratio = Liquid Assets (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

This ratio specifically measures your small business’s ability to turn assets into cash. This is then used to pay off your liabilities. It measures the dollar amount of assets your small business has available. Therefore, the higher your quick ratio, the better you will be at paying your bills. For example, if you have a quick ratio of 1.75, this means you have $1.75 of assets for every $1 of current liabilities.

Current Ratio = Current Assets / Current Liabilities

This ratio showcases your small business’s ability to pay off your short-term liabilities. A high current ratio means that your small business is able to pay off short-term financial obligations effectively. A low ratio means you may have some trouble meeting your financial obligations. For instance, if your small business’s ratio is under 1, then that indicates a low ratio and potential trouble paying what you owe. Overall, the higher your current ratio is, the better.

Debt/Equity Ratios

These ratios show the amount of financing that comes from investors. If you have a high ratio, it indicates that you used more bank loans than investor financing.

Higher ratios also can mean that your company has been using debt to grow. If this is the case for you, remember that you’ll have to pay this debt eventually. Also, keep in mind that a high ratio is not necessarily a good sign for your small business. It means that you may have trouble paying your debt in the future. Typical ratios depend on the industry you’re in. However, most businesses want their ratio to be below 5 or 6. Investors have been known to get nervous with ratios in or above the 5 to 6 range.

Debt/equity ratios include:

Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity

Long-Term Debt/Equity Ratio = Long-Term Debt / Shareholders Equity

Short-Term Debt/Equity Ratio = Short-Term Debt / Shareholders Equity

Working Capital Ratios

This ratio calculates if your small business will be able to meet your bills, payroll, and loan payments. High ratios generally mean you will be able to meet your payments. Typically. a ratio of 2.0 indicates a good ratio. Ratios less than 1.0 are an indicator of problems.

The ratio is: Working Capital = Current Assets – Current Liabilities

The solvency ratios, debt/equity ratios, and the working capital ratio are just a few of many ratios you can use when analyzing your balance sheet.

In fact, you should keep an eye out for these ratios as well:

Activity Ratios

These measure how effectively your small business converts assets into cash. High ratios here let you know that your inventory is being sold and converted into cash at a fast rate. These include:

Days sales outstanding. This ratio measures how fast a small business converts receivables into cash. A high ratio lets you know that you’re selling a lot of products or services on credit but taking a long time to collect your receivables from those sales. Lower ratios mean you collect your receivables in a shorter amount of time. For reference, a ratio under 45 is usually considered low. That being said, remember that these ratios can depend on what industry you are in.

Days inventory outstanding. This is the financial ratio that measures the average number of days your small business holds onto inventory before it gets sold. For example, say you have a turnover ratio of 10. This means your inventory turned over 10 times throughout the year. Small businesses typically prefer lower ratios. However, the industry you are in influences what is considered a good ratio. For instance, Walmart has been found to turn over its inventory every 44 days. Small businesses that sell only perishable food items would likely sell inventory faster than this.

Days Payable Outstanding Ratio. This ratio calculates the amount of time your small business takes to pay back your creditors. A high ratio tells you that your small business is paying suppliers at a slow rate. Generally, most businesses have a ratio of around 30. This means that it takes them about 30 days to pay their suppliers.

As you calculate these ratios, make sure that you compare your numbers to previous time periods and to your competitors. This will help you determine if you have a good ratio or not. I often suggest to my clients to compare their financial statements to industry leaders. For example, all publicly traded companies must release financial statements to the U.S. Securities and Exchange Commission.

The Importance of a Comparative Balance Sheet

By now you know the importance of analyzing your balance sheet, but there’s another piece to consider. That is the comparative balance sheet. Your comparative balance sheet shows your small business’s assets, liabilities, and shareholders’ equity in multiple time periods. For example, comparative balance sheets often show the past year, or the past three years. Sometimes, comparative balance sheets will show your finances for the end of each month over the last year.

The information for different time periods is shown side by side for easy comparison. Why is this beneficial? Because it shows how your assets, liabilities, and shareholders’ equity has either grown or decreased over time. This can help you make more educated decisions about your finances for the future.

After you’ve completed your balance sheet and analyzed it thoroughly, you’ll want to do it again in the future. Small businesses that continue to analyze their financial standing can make better business decisions. Remember to compare your ratios to previous time periods and to compare your most current balance sheet to your previous ones. These comparisons will yield new insights that can help your small business grow, build stamina in the market, and stay on your customers’ map for good.

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