The Balance Sheet statement is one of the essential financial statements used by investors, accountants, and business owners (the other essential financial statements being the Profit and Loss and Cash Flow Statement). It is used to determine the liquidity of a business, through the use of ratio analysis, at the end of a specified date. Liquidity measures the ease with which an individual or company can meet their financial obligations with the liquid assets available to them. The Balance Sheet statement is sometimes referred to as the statement of assets, liabilities and equity, B/S, or the statement of financial position.
The Balance Sheet is based on a fundamental accounting equation (Assets = Liabilities + Owners’ Equity) and is designed to show the financial position of a business at the end of a specific date. In other words, the Balance Sheet reports a “snapshot” of a business’ financial position at a point in time, as if the business were momentarily at a standstill. The financial position reflects:
- What assets the business owns
- How it paid for its’ assets
- What credits and loans the business owes
- What is left after satisfying all of its’ liabilities
For Business Owners and Managers
The Balance Sheet provides the information necessary to calculate a plethora of financial ratios. For business owners and managers, the following ratios are important:
Current Ratio = Total Current Assets / Total Current Liabilities
Explanation: Generally, this metric measures the overall liquidity position of a company; by calculating the number of times short-term assets cover short-term liabilities. It is certainly not a perfect barometer, but it is a good one. Watch for big decreases in this number over time. Make sure the accounts listed in “current assets” are collectible. The higher the ratio, the more liquid the company is.
Quick Ratio = (Cash + Accounts Receivable) / Total Current Liabilities
Explanation: This is another good indicator of liquidity, although by itself, it is not a perfect one. If there are receivable accounts included in the numerator, they should be collectible. Look at the length of time the company has to pay the amount listed in the denominator (current liabilities). The higher the number, the stronger the company.
Working Capital = Total Current Assets – Total Current Liabilities
Explanation: This is the capital that finances continuing operations of the company. It is normally used to manufacture, sell, and receive payment for products and services. Working Capital shows the available liquidity resources after current obligations are met. The higher the better.
Debt-to-Equity Ratio = Total Liabilities / Total Equity
Explanation: This leverage ratio indicates the composition of a company’s total capitalization — the balance between money or assets owed versus the money or assets owned (percentage of assets financed through borrowing and the extent of trading on equity). Generally, creditors prefer a lower ratio to decrease financial risk while investors prefer a higher ratio to realize the return benefits of financial leverage.
Keep in mind that there are additional financial ratios to help assess the performance of inventory, collection efforts of accounts receivable, return on the investment of assets, etc.
For Lenders and Investors
A business’ current financial position is crucial to know. The Balance Sheet shows lenders and investors what a business owns as well as what it owes to lenders. Lenders and Investors use the Balance Sheet to perform ratio analysis on the business’ liquidity. This helps them determine whether or not a business qualifies for addition credit or loans.