Financial Statements Part 2: Balance Sheet
The Balance Sheet or Statement of Financial Position is the second of the three primary financial reports (see last week’s solution for a walk thru of the Income Statement). The Balance Sheet shows the value of the ownership and obligations of a business at a particular point in time. It is often described as a “snapshot of a company’s financial condition” because it shows all assets, liabilities and equity as of a specific date, such as the end of its financial year.
A standard company balance sheet has three parts: Assets, Liabilities and Equity. The basic tenet of accounting practice establishes that the value of Assets must equal the sum of Liabilities plus Equity. The following charts list typical accounts in each category and include notes regarding confirmation of balances and their treatment.
The Asset section shows what the company owns. The balances in the “Current Assets” section are assets that (theoretically) can be converted into cash in less than one year. The non-current assets are intended to serve the company for more than one year (such as equipment) or that may have contingencies tied to their disposition (like Deposits.)
The Liabilities section tracks what the company owes to others. It is divided into “Current Liabilities”, which are typically obligations that are due within one year, and “Long Term Liabilities”, which are obligations of the company that become due more than one year into the future.
The Equity section shows the residual value of the business. It includes the ownership of the company (by owners, investors, and employees), as well as a cumulative total of all past Net Income classified as Retained Earnings.
Balance Sheet information is most often used by company management, their investors, and creditors to measure the financial health of a company. Here are some of the most frequently calculated ratios:
- Assets to Liabilities: as a long-term sustainability indicator, the ratio should be greater than 1:1 (Total Assets exceed Total Liabilities)
- Current Assets to Current Liabilities (also called the Current Ratio): the short-term liquidity measure should also exceed 1:1 indicating that easily convertible assets would produce adequate cash to satisfy near-term obligations
- Debt to Equity: shows how much of the business has been funded by owners versus held by creditors so is favorable when it is less than 1
- Days Aging of Accounts Receivable: can indicate a potential collections problem if the average days calculated exceeds the company’s standard terms
- Days Aging if Inventory: similar to A/R, if Inventory Days exceeds the average days from order to delivery, there may exist an increased risk of obsolescence
Although every account on the Balance Sheet can be analyzed, the most meaningful relationships between accounts are determined by the type, age, and future plans of each business. Business owners should work with their financial advisor to identify the metrics that best keep them on track to reach their goals.