Analyzing Your Balance Sheet

By Randall Orser | Small Business

Balance Sheet Word Cloud Concept in red capsAs a home business owner, you need to take time out to look closely into your financial statements. Whether they are prepared by your accountant or generated by your accounting software, your financial statements can tell you much about your business, some of which you may not even be aware. Take the balance sheet, for example. It gives you a picture of what you own, what you owe, and how much your net worth is as of a certain date. Knowing how to analyze your balance sheet will help you see from afar how your business stands, and how stable and strong it is. If you see anything wrong with your business finances, you can take timely action to correct and improve your standing. This is particularly useful when you are applying for a loan, getting accreditation, or looking for potential investors.

Know What’s in Your Balance Sheet

Understand the different accounts used in your balance sheet and how they relate to each other. Do not be content in looking at the totals of your assets and liabilities and your net worth. Study the figures to determine your financial health. Calculate your working capital. Your working capital is your current assets less your current liabilities. Does the amount give you enough elbowroom for your operations? If you have been experiencing difficulties meeting your bills, this will be reflected in the low level of your working capital.

Then again, if you are still unable to pay your creditors on time despite the substantial amount of your working capital, the reason could be traced to the quality of your current assets, which in turn points to inefficiency in your operation. Your money could be tied up in receivables that you have not had time to collect or inventory that is slow moving. On the other hand, if your current liabilities exceed your current assets, you are in trouble as you do not have the means to immediately meet your obligations. A more in-depth analysis is needed and you might have to pump in more capital if you want to stay in business.

Learn How to Use Ratios

Ratio analysis can be very useful in assessing the strength and stability of your business. Your current ratio (current assets/current liabilities) indicates how well you cover your payables. Generally, a 2:1 ratio is desired although anything more than 1:1 is acceptable.

A more stringent measure of your liquidity is the quick ratio or the acid test ratio. This is computed as (current assets – inventory)/current liabilities and shows your ability to pay your bills even during unfavorable conditions provided, of course, that you can make timely collections on your receivables. A ratio anywhere between 0.5:1 and 1:1 is considered adequate.

By knowing your debt-to-worth ratio, you can gauge your dependency on debt to finance your home business. The formula is total liabilities/net worth. It shows you how much your lenders have at stake in your business compared to yours. Although the leverage ratio differs according to the nature of business, banks are wary of loan applicants with high debt-to-worth ratios.

Compare

Your balance sheet gives you a snapshot of your financials as of a given date but you should compare it with your previous statements. This will give you an idea of how your home business has expanded. Calculate the growth rates and look for trends. Any dramatic increase or decrease in any account, especially if unplanned, should be accounted for as it can indicate potential problem areas like uncollected receivables, unnecessary stocking in inventory or over reliance on short-term borrowings. Compare the key ratios and note any improvement or deterioration. It would even be more helpful if you can compare your figures with your competitors’ or industry average as that would show how you are faring.

No matter how busy you are, you cannot afford to stay immersed in your operation. Stay on top of your business. Analyze your balance sheet, know its components, and understand the changes that are going on.

About the Author

Bookkeeper Extraordinaire
Number Crunchers® Financial Services

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