How to read a balance sheet
Does glancing at your balance sheet look like a foreign language to you? Do you try to delve a bit deeper into the numbers you’re seeing only to end up frustrated? Do you generally hate numbers and don’t even have the patience to try and understand your balance sheet? Well, you’ve come to the right place. See below to find out how to read a balance sheet.
Cloud accounting systems (check here for the best cloud accounting options for your business) now give you access to your balance sheet whenever, wherever, and it’s important to take a look at your balance sheet on a regular basis
A balance sheet is a part of your financial statements and is a snapshot of your company’s assets (what you own), liabilities (what you owe) and equity at a particular point in time. Remember, a critical component of a balance sheet is that we are not looking at a balance sheet through a range of dates, but on a specific date.
Knowing how to read your balance sheet is important for several reasons. It can tell you how liquid you are, how solvent you are, it can point to certain trends as well as show certain levels of risk. We won’t dive deep into complicated ratios, we’ll leave that to your accountants. But there are a few simple analysis techniques out there that can certainly help you get a better understanding of your business’ position at a given point in time.
Compare your numbers!
If you’ve been in business for several years, a balance sheet will usually show your current year’s numbers in 1 column as well as the previous year’s numbers in another column. It’s always a good idea to compare these numbers.
For instance, if you noticed that your accounts receivable balance has doubled from last year to this year, that could be amazing news because you might remember that your sales have actually doubled from the prior year, so keep up the good work!
But if your sales haven’t doubled while your accounts receivable have, then this is something that needs to be investigated. Why? Because it might indicate that you have not collected on your accounts receivable fast enough, or even worse, it could indicate bad debts.
Comparing your cash balance is always something to look out for as well, as cash is your company’s lifeline, without it, your company can’t survive.
Personally, I always look at each and every balance sheet line and compare the numbers to the prior year just to make sure everything is in line and I would recommend you to do the same. If something looks out of line, then investigate. Hopefully your accountant is ahead of you on this and is already doing the investigating on your behalf.
It’s all about liquidity
Liquidity means how capable your business is to pay off its upcoming or immediate liabilities for the coming year (ie. your current liabilities). If you cannot pay off these liabilities with your assets, then you will surely have a problem continuing the business.
A very quick way to determine if you are liquid is to compare your current assets to your current liabilities. To determine which assets are current, consider which assets can be easily converted to cash within 12 months. Obviously cash is a current asset. Accounts receivable are also usually considered current assets as standard collection terms are 30 days. So if you have $100,000 in current assets and $30,000 in liabilities due within the upcoming 12 months, we can assume that the business is fairly liquid and will have no issues paying off these obligations.
Liquidity is essential for the future operation of your precious business, so keep an eye on it.
Lesson number 2: Identify your current assets and current liabilities in order to determine whether your business is liquid or not. If not, don’t panic! Talk to your accountant before you do anything, there are always solutions.
Long term debt & solvency
You may have had a spectacular idea for a new mobile app or a web-based business, but in order to get that idea to market, you had to take out a sizable loan. Loans of this nature are normally paid out over a period of time that is longer than 1 year and is therefore considered long term on the balance sheet. Assessing your ability to pay your long term debt obligations on time is critical for any business and refers to the concept of solvency.
We won’t get into anything too technical here, but essentially, we want to compare our equity on our balance sheet (ie. the owner’s net worth in the company) versus the amount of long term debt outstanding on the balance sheet. Generally, the higher this ratio is, the more solvent your business is, yahoo!
Your balance sheet and you
There are tons of technical ways to examine your balance sheet, but what’s important for the majority of micro business owners out there is that they have some comfort over their business’ balance sheet. You can leave the fancy stuff to your accountants, but at the end of the day, it is your business, so take control!