What did you learn? The company has $120,000 in assets and $100,000 in short and long-term liabilities. As a result, it has Net Assets of $20,000. Of that $20,000, $4,000 was capital provided by shareholders, with the other $16,000 the result of profitable operations.
So why is it called a Balance Sheet? Assets, or the means used to operate the company, are balanced by financial obligations, equity investment, and retained earnings. It's a simple formula: Assets = Liabilities + Shareholder Equity. Both sides of the equation must be equal, or balanced.
You can learn a lot from a Balance Sheet, like whether how much a business owns is more than it owes, whether its debt is mostly in short-term notes or long-term obligations to suppliers or long-term loans to the bank, whether the shareholders invested a majority of the capital up front, or whether the business has grown organically with profits it has made.
Balance Sheet Terms
- Current Assets. Assets with a life span of one year or less; can be easily converted into cash. Includes cash, inventory, and accounts receivable.
- Fixed Assets. Assets with a life span of over a year: not easily converted into cash. Includes equipment, buildings, land, and even patents or copyrights.
- Current Liabilities. Debts which must be paid within one year. Includes accounts payable, interest on long-term loan payments, and short-term financing (for example, company credit card payments).
- Long Term Liabilities. Debts and other financial obligations due over a year from the date of the balance sheet.
- Capital. Funds provided by investors.
- Retained Profit. Profits kept and not spent. Can be used to finance additional assets or just put away for a rainy day.
In short, the Balance Sheet shows assets and how much is still owed on those assets. The result, Net Assets, is the value of the business.
Evaluating a Balance Sheet
Once you create a Balance Sheet you can use it to evaluate the financial performance and health of a company. Here are a few calculations you can perform.
Quick Ratio (QR)
The Quick Ratio is sometimes called the "liquidity ratio" or the "acid test ratio." The Quick Ratio measures the liquidity of a company by determining the ratio between current liabilities and assets that can be quickly converted into cash.
Quick assets include things like cash and accounts receivable. Inventory is excluded from liquid assets since one of the goals of the QR is to determine if current liabilities can be paid without selling inventory. Inventory should hopefully always be sold to generate profits, not simply to cover expenses.
Here's the formula:
Quick Assets / Current Liabilities = Quick Ratio
Here's an example. Say a business has $40,000 in cash and $20,000 in liabilities.
40,000 / 20,000 = 2.0
The QR is 2.0; the company has double the liquid assets available needed to pay off current liabilities.
A company with a QR lower than 1.0 may not be able to meet debt obligations without taking drastic measures like selling assets or borrowing additional funds. A low QR creates another problem, because lenders are often unwilling to make loans to a company with a QR below 1.0; if the company is struggling to meet current liabilities, adding more debt may only aggravate the problem.
The QR is in no way an absolute measure of business health, but it does indicate whether a company can put its hands on funds in hours or days without having to resort to selling inventory or hard assets. A company with a high QR is relatively solvent and has a built-in buffer against short-term cash flow problems.
Current Ratio (CR)
The Current Ratio (sometimes called the Working Capital Ratio) measures a company's liquidity. A high CR indicates the company has sufficient cash or assets to meet normal operating conditions. A low CR could mean the company uses more of its assets to grow the business. Assets include cash and other items including inventory that could be converted to cash; liabilities include debts and obligations that are expected to be settled within a year.
Here's the formula:
Current Assets / Current Liabilities = Current Ratio
Here's an example. Say a business has total assets of $500,000. Its current liabilities (the money it owes) total $120,000.
500,000 / 120,000 = 4.16
The Current Ratio is 4.16. (Keep in mind that if assets equal liabilities, the Current Ratio is 1.)
In most industries, if the CR is over 2, a company is generally considered to have good short-term financial strength. If the CR is under 1, and liabilities exceed assets, the company is clearly struggling, at least in the short term.
Another way to view CR is in dollar terms. Say your company has assets of $100 and liabilities totaling $34. The CR is 2.94, or, put another way, the company has $2.94 in assets for every dollar you owe.
Comparing CR over time is helpful. If CR decreases, that could be an indication a company is carrying too much inventory or is struggling to collect receivables in a timely fashion. If the company is not taking on more debt and revenues are increasing, then its CR should improve — or something is wrong.