How to Use a Balance Sheet to Evaluate the Health of Your Business?

A balance sheet is part of a financial statement that shows the current financial position of a company. This accounting statement shows assets and liabilities of a company. In addition, this financial statement also shows the equity belonging to the owners or shareholders.

The format used to create a balance sheet is similar for all companies. This financial statement can be used to compare the performance of both large and small companies. In addition, the statement of financial position can also show the company’s performance across a period of  time.

Lets now get into how you can evaluate a company’s financial health using the balance sheet. You will learn about financial ratios, which can be calculated using the elements of the balance sheet.

An Overview of the Balance Sheet

A balance sheet provides a snapshot of the business at any given time. The financial position of the company is broken down into assets, equity, and liabilities. The financial statement provides a lot of information that can be useful for stakeholders.

The investors, company management, and owners or shareholders can review the balance sheet to find out if the company is in sound financial condition. Looking at the financial statement, the stakeholders can know whether the company has taken too much debt and can create internal projections.

Internal management and employees can also look at the balance sheet to find out if the company is on the path of success or failure. Management can review the information and use it to make informed financial decisions. They can take early action to improve the long-term financial position of the company.

Investors can use the information presented in the balance sheet to make decisions about whether to buy shares in the company. Creditors can also review the information to find out if the company can pay back their debt.

Stakeholders can calculate key metrics using information in the balance sheet. Some of the important metrics that help identify the financial position of the company include debt-to-equity ratio, profitability, and liquidity.

External auditors can also get vital information about a company by reviewing the balance sheet. They can audit and verify debt and other information by looking at the balance sheet.

An important thing to remember regarding the balance sheet is that it provides information regarding a specific date. The information pertains to past performance of the company. And past performance is no guarantee about the future performance. So, you should not base investment decisions based on the information in the financial statement.

The Balance Sheet Equation

The balance sheet of a company is based on the following accounting equation:

Assets = Liabilities + Equity

The above equation is the most common and standard format of the balance sheet. But the balance sheet of a company can also be organized as a follows: 

Liabilities = Assets – Equity

Equity = Assets – Liabilities

A balance sheet’s accounting equation should always be balanced. This means that the right side of the equation must be equal to the left side. If any side of the equation does not balance, it means that there is some error in preparing the balance sheet.

Most errors are due to missing transitions. The errors in cash balance, depreciated assets, and equity are common when preparing a balance sheet.

Important Elements of a Balance Sheet

Here we take a close look at the important element of a balance sheet.

1. Assets

Assets are the top line of a balance sheet prepared by most companies. The asset includes properties owned by a company. Some of the common assets shown in the balance sheet are as follows.

• Long term Assets
  • Plant
  • Property
  • Office equipment
  • Furniture and fixtures
• Short term Assets
  • Accounts receivable
  • Cash
  • Inventory

2. Liabilities

Liabilities refer to money that is owed to creditors. This section shows both short term and long term loans.

Investors and creditors would want a high asset to liabilities ratio. Companies that have more liabilities than assets are usually in trouble. They are less likely to repay the loan and even go bankrupt.

Similar to the assets section, the liabilities section also contains short-term and long-term liabilities. The short-term liabilities section consists of accounts payable, short term loan, customer deposits, and deferred income.

Long term liabilities include long term loans that are due after more than a year. Investors make sure that the company hasn’t taken too much long term debt.

3. Equity

The equity section of the balance sheet shows the capital invested by owners or shareholders in the business. This section also includes retained earnings, which shows the portion of profit retained by the company. Retained earnings can be used to pay off debt or can be used to reinvest in the business.  

Equity considerations are important when making a decision about purchase or merger with the business.

Using Balance Sheet to Calculate Ratios

The different elements of the balance sheet can be used to calculate important accounting ratios for evaluating the financial health of a company.

Current ratio is the ratio between current assets and current liabilities. The ratio should be ideally 1 or more. A ratio that is less than 1 shows liquidity issues, as the company will have difficulty in meeting short term debt obligations.

Assets turnover ratio reflects the difference between sales and assets. The ratio shows efficiency of the company in utilizing assets to generate sales.

Lastly, inventory turnover ratio is important in evaluating the performance of manufacturing and other companies that hold inventory. The ratio shows the difference between sales and inventory. A high turnover shows strong sales due to strong demand of the product.

Conclusion

A balance sheet shows the financial position of the company. It reflects what the company owns and owes at any particular time. You can learn a lot by looking at different sections of the balance sheet.

The assets, liabilities and equities mentioned in the balance sheet can be used to evaluate efficiency, liquidity and financial structure of the company.

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