Spring has sprung, the grass is green, the books are closed, and the balance sheet looks clean.
Over the course of the last few months, I have had the privilege of presenting a number of sessions focused on how to read and understand financial statements. The sessions were well attended, and the depth-of- discussion questions brought me a deeper understanding of how financial statements are an area of confusion for many people.
The balance sheet for example — by definition a balance sheet “balances,” meaning that assets equal liabilities plus equity. Said another way, assets minus liabilities equals equity. The balance sheet provides a snapshot in time of your enterprise’s worth, and potentially so much more.
By developing an understanding of what the balance sheet represents, you can assess and potentially improve the stability of your enterprise.
Let’s start with working capital, which measures liquidity. Higher working capital ratios indicate that a larger portion of the company’s resources are invested in current assets such as cash, inventory, or accounts receivable. A lower ratio indicates a more significant investment in long-term assets such as property and might indicate that a short-term cash crunch is on the horizon. Working capital is easily calculated as current assets divided by current liabilities.
Many businesses do maintain debt relationships with banks. The debt-to-equity ratio measures the extent of this relationship and is computed by dividing total liabilities by owner’s equity (stockholder’s equity or member’s equity). The debt-to-equity ratio is an indicator of a company’s credit worthiness and the current reliance on borrowings to sustain the business. Demonstrating a high or rising ratio is almost certain to cause challenges when looking to secure debt.
Knowing how often your accounts receivable (A/R) turn over allows you to assess cash flow; by knowing the average number of days A/R outstanding, a business can monitor the effectiveness of cash-collection procedures. The computation is a two-step process. First, divide annual sales by the average accounts receivable for the period. Divide the number of days in the period (365 for a year) and you have the average number of days A/R outstanding. A quicker collection of cash can mean paying less interest to the bank because reduced line-of-credit borrowings, or the ability to take advantage of discounts with vendors.
Inventory is often a key number on the balance sheet. When this is the case, close monitoring is important. The inventory turnover, which is calculated by dividing purchases by average inventory, provides a metric by which to manage inventory. A high number indicates the company is continually turning over materials. In contrast, a low number could be an indication that the company is carrying excessive inventory. When inventory is on hand for a lengthy period of time, the costs incurred to carry the inventory can have a significantly negative impact on the bottom line and ties up cash.
Cash flow can be measured in a number of ways. By taking a ratio approach, a business is able to quickly monitor cash-flow adequacy. Cash flow from operations needs to exceed the demands of debt repayments, plus acquisition of property, plus distributions to owners. Divide cash from operations by these items to get a read on the adequacy of cash flow. A ratio that exceeds 1 is an ideal goal. Remembering the old phrase “cash is king” never hurts.
While none of these measurements tell the entire story on their own, in combination, they can provide a means to measure and monitor how well your business uses assets.
Whether you are considering sharing financial information for the purpose of raising capital or to comply with lending requirements, it is important to understand the story the balance sheet reveals. Trust me; these measurements are sure to be evaluated. Did increasing sales really provide a benefit? Is your business truly bigger or stronger? These balance-sheet assessment tools can provide valuable insight.
Every business, no matter what the size, has ratios for the taking. Contact your CPA to improve your balance-sheet savvy and learn how to use the key business metrics discussed here as well as those which may be unique to your enterprise.
Gail Kinsella is a partner in the Syracuse office of The Bonadio Group accounting firm. Contact Kinsella at gkinsella@bonadio.com