By Sandra Taylor-Sawyer: CNJ columnist
One of the most important tools that can be used to analyze a small business’s financial condition is its balance sheet.
A balance sheet is a “snapshot” of a business’ financial status on any particular day. There are three parts to every balance sheet: assets, liabilities, and owner’s equity. The sum of liabilities plus owner’s equity must always balance with the assets. This is where the term “balance sheet” originates.
Total assets consist of current assets and fixed assets. Current assets are any asset that will convert to cash in one year or less. Usually these assets are cash, accounts receivable, supplies and inventory. Fixed assets consist of property the business owns such as buildings, equipment and fixtures. These assets are defined as having a life longer than one year.
The second balance sheet category, total liabilities, is defined as debt the business owes. Liabilities are divided similar to total assets: current and long-term liabilities. Liabilities that are current will be paid in one year or less. The remaining liability (long-term) or debt will take more than one year to pay. Current liabilities consist of accounts, taxes and notes payable. Business loans and mortgages on property are classified as long-term liabilities.
The difference between total assets and total liabilities is called owner’s equity or net worth. Net worth is increased by cash injections made by the owner and profits of the business (net income). It is decreased by cash withdrawals and expenses of the business (net loss).
There are two measures that can be determined from a review of the balance sheet: debt and liquidity. Debt indicates how much of other people’s money is being used by the business to operate. Liquidity is the ability to meet financial obligations.
The most dependable indication of liquidity is called “current ratio” and is calculated by simply dividing current assets by current liabilities. A current ratio of 2:1 would indicate that a company could lose 50 percent of its current assets and still be able to meet its current liabilities. Most analysts or lenders would consider this a good margin of safety. The percent of owner’s equity is calculated by dividing owner’s equity by total liabilities and multiplying by 100. Most lenders like to see a percentage of at least 30 percent unless there are other guarantees. The more indebtedness a business has the greater the risk of failure.
Ratios from the balance sheet can be utilized as a report card at the end of a year, comparing it to past years or to similar businesses. It is important for a business owner to analyze and interpret the business’s balance sheet and other financial data on a regular basis.
Sandra Taylor-Sawyer is director of the Small Business Development Center at Clovis Community College. Call the center at 769-4136 or visit www.nmsbdc.org/clovis