How To Understand A Balance Sheet
In business, having a firm grasp on the numbers is one thing - but if you're wondering how to understand a balance sheet, rest assured you're not alone.
Any business can read their balance sheets at any given moment in time, in order to better understand the company’s accounts and financials. In simple terms, the process involves analyzing your business’s reported assets, liabilities and equity, with the end goal being to get a clear picture as to what your company owns and owes.
When it comes to understanding a business, there are few financial statements more important than the balance sheet, as it offers critical insight into the financial health of a business, and can be used by:
Potential investors, to decide whether to invest in a company
Business owners and management, to craft more effective organisational strategy
Employees, to adjust their processes to better reach shared organisational goals
Although deciphering data and numbers certainly isn’t a strong point for all traders, the good news is that learning how to understand a balance sheet is a relatively straightforward process.
Learning How To Understand A Balance Sheet
In business, there are usually two types of balance sheets: current and noncurrent. The major difference between the two is the anticipated timelines associated with their use.
Current - Includes assets that the business owns or has a claim on, that can be quickly converted into cash. Examples can include stock and debtors. It also includes current liabilities, or obligations that will soon be due, such as credit card debts, interest or overdraft fees, wages, tax liabilities, superannuation and creditors. The liabilities of smaller businesses are usually smaller, unless there are loans or other liabilities that aren’t repayable for more than a twelve month period.
Noncurrent - Includes debts that are not payable or due within twelve months of the balance sheet date, and can include long term loans or director’s loans. Noncurrent assets are those that the business intends to keep and not convert into cash over long periods of time, such as plant and equipment, company motor vehicles, office equipment and fitouts. These forms of assets are ones that usually depreciate in value, meaning that the tax deduction for the expense is spread across multiple years, as opposed to one claim in a single year.
At a quick glance, your brand’s balance sheet will indicate if your business has the resources available to manage and handle the standard financial swings any business should anticipate, otherwise known as working capital. This term is used to define the difference between your current assets vs your current liabilities, or how much cash you have to “work” with.
The exact amount of working capital a business needs will vary over the course of a financial year, which is why it’s crucial to know how to understand a balance sheet in order to assess and accurately predict any shortcomings that could have otherwise taken you by surprise. This is calculated by minusing your current liabilities from your current assets - the amount leftover is the working capital available to your brand or business.
Calculating your brand’s working capital ratio is done by combining the above principles with slightly more maths - think along the lines of current assets divided by current liabilities. An example of this is if your brand’s current assets are $120, 000 and current liabilities are $80, 000 - then your working capital ratio is 1.5:1.
If you’re in the process of learning how to understand a balance sheet, another relatively straightforward tool that your financial team can deploy is the debt to asset ratio. This is calculated by dividing your total liabilities by your total assets. An example of this would be if your total liabilities are $110, 000 and total assets are $150, 000 - then your debt to asset ratio is 0.73:1.
As a general rule of thumb, the higher ratio the more your business is considered leveraged and therefore at risk. A score over 1 means you have more debt than assets whereas a score of 0.5 or lower would put you at less risk. If you have a high debt to asset ratio, it usually means that you’re growing your business by taking on debt (either through loans or creditors) rather than from reinvesting profits the business has made. However, creditors and investors such as banks do use your debt to asset ratio in order to assess how risky it is to potentially loan your business money - the higher the ratio, the riskier you are, which makes it difficult to obtain a loan or attract investors who may use this ratio to see how solvent your business is.
Where To Source Help With The Finances Of Your Business
Whether you’re starting a business, purchasing an existing one, or even reevaluating where your current one stands - all require some form of financial know-how if you hope to successfully navigate your legal requirements as well as hitting your business goals.
However, if understanding the legalities that surround your business or finances isn’t your strong point, then it may be reassuring to know that you’re not alone. In fact, many businesses (big and small) enlist the services of an accountant in order to free up their time while knowing that their financial obligations are already taken care of by the professionals.
Ultimately, the team at Muro believe that every business owner is an entrepreneur. However, accounting does not discriminate - finances break down barriers and are not territorial. If you would like to take a deeper look into your finances, please get in touch with us at Muro today to ensure that you’re on the right path for success.