In the previous lesson, we gave you a quick step-by-step walkthrough on how to create a balance sheet for your online business. Now, let’s talk about the various methods you can use to analyze and read the balance sheet. We’ll be covering how you can use the statement to arrive at conclusions, spot patterns, notice errors, and formulate strategies based on them.
Why should you know how to read a balance sheet?
Knowing how to read a balance sheet is an incredibly important skill to have. Even if you hire an in-house team of accountants or analysts to offer you their expert opinion on the business, you should have some basic understanding of how to do it. Balance sheet analysis covers every sphere of your decision-making, not only as a business owner but also as an investor, a service provider, and an entrepreneur.
Balance sheet analysis: where to start?
There are plenty of ways you can go about reading your balance sheet. This depends on what insights you wish to obtain. Ratio analysis is highly important in this regard because it gives you a clear and concise way of representing results. Business owners apply ratio analysis to gain relevant information about the company’s overall liquidity, solvency, and profitability.
- Liquidity is basically a measure of your ability to convert business assets into cash. Let’s say your online business has a high reserve of cash in hand by the end of the year. Then a related ratio analysis would reveal that your business is highly liquid.
- Solvency is a measure of how capable your business is at paying off debts and liabilities. It includes values such as net income, depreciation and
- Profitability measures how profitable your business is. In other words, the level of income you’re capable of generating on a consistent basis.
Just about every ratio analysis we’re about to cover encompasses all the above three. Let’s walk you through some of the related ratio analyses that pertain to them using a balance sheet example:
Here is the balance sheet of a fictional company called Sal’s Super T-Shirts, an online business.
The following are some of the ratios we can derive and insights we can infer from this balance sheet.
This is a form of ratio analysis that offers insights into the company’s liquidity. In other words, it shows you what degree of the company’s assets can be converted into cash compared to its liabilities. This can be a good indicator of how fast the company can pay off debts and maintain operations. Here is how it is calculated:
Current Ratio = Current Assets : Current liabilities
Sal’s Super T-Shirts balance sheet reflects that its total assets amount to an impressive 110,000. The total liabilities are around a relatively lesser 32,000. Current assets would exclude fixed assets such as equipment, which gives us 100000. Current liabilities would exclude long-term loans which makes it 20,000. So the current ratio is:
Current Assets: Current Liabilities
1,00,000 : 20,000 = 5: 1
In other words, there are five times as many assets as there are liabilities. This indicates an extremely successful business that is more than capable of paying off debts, reinvesting and growing rapidly.
Quick ratio excludes the assets that cannot be converted to cash any time soon, namely, inventory (closing stock). So the formula becomes:
(Current Assets – Inventory) : Current liabilities
This way you can evaluate how quickly your business can convert most of its assets into cash to pay off liabilities while still maintaining a profit.
The quick ratio for the above example becomes:
(100,000 – 20,000) : 20,000 = 80,000 : 20,000
Again, this indicates that the business has major liquidity given that it possesses 4 times more quick assets (cash and imminently convertible assets) than liabilities.
This can be calculated by including cash assets alone, along with any convertible investments. The formula we use to determine this is:
Cash assets : Current liabilities.
In this case, the above example becomes:
30,000 : 20,000 = 3 : 2.
The business has a third more in cash assets that exceed liabilities. This indicates that Sal’s company is doing moderately well in retaining cash assets. There is enough to cover all immediate liabilities and enough to spare.
Debt to equity ratio
This ratio indicates the proportion of money your business owes to creditors compared to the annual equity. The formula is:
Debt-to-equity ratio = Outstanding debts : Equity
In the above example, we have accounts payable estimated at 18,000. The annual equity (assets- liabilities) is 10,000. So the debt-to-equity ratio for Sal’s business becomes:
18,000 : 10,000 = 9 :5.
This is actually an optimal ratio for the business.
The working capital is yet another particularly important measure that determines how well and capable your business is to finance future operations. You can obtain it from the balance sheet by simply deducting liabilities from assets.
Working Capital = Current Assets – Current Liabilities.
In the above example, this is what it would look like:
Working Capital – 1,00,000 – 20,000
This is highly favorable. It indicates a surplus of 4 times the amount in liabilities, which Sal’s business can use to invest towards financing operations and growth.
The solvency uses net income, depreciation and total liabilities to find out whether or not you’re capable of managing your debt-levels. A higher solvency ratio indicates a stable business. Solvency ratio is calculated as follows:
Solvency ratio = (net income + depreciation) : total liabilities
You can obtain the net income and depreciation from your business’s income statement. For this example, let’s assume net income amounts to 49,000 and depreciation is 10% annually for the equipment, which, in this case would be 1000 dollars.
Here, we’d have:
Solvency ratio = (49,000 = 1000) : 20,000
= 50,000 : 20,000
In other words, the business is very capable of managing debts for the year.
Days Sales Outstanding
This gives you a measure of how many days worth of sales your accounts receivable figure depicts. The metric helps you get a gauge on how well you are managing receivables and the state of your business compared to other companies.
DSO = (Accounts Receivable/Credit Sales) * Number of Days
In other words, it shows you how many outstanding sales your business has in terms of days. The lesser this figure is, the better off your business will be.
You’ll find the net credit sales for the business in the income statement. For this example, let’s assume it is 30,000. Accounts receivable here is 20,000. Let’s say the number of days is 300.
So DSO = 20,000 / 30,000 x 300
In other words, the business is yet to receive 200 days worth of sales in credit.
When you compare your DSO figure with that of other companies, you’ll be able to tell how well you’re doing and how capable you are at managing credit. The DSO metric is important to know because any money that you have yet to receive can actually be used to fund your business and grow it further.