Everybody Has a Favorite
Humans are quite discerning creatures. Having the ability to reason confers the ability to have favorites. And as the title implies, everybody has a favorite. A favorite hobby, favorite food, favorite song or sport or book or movie… the list goes on and on.
Breakaway Advisor
Hey, even though accountants typically get a bad rap (as bean counters and boring), we also have favorites. While a complete set of financial statements provides an all-inclusive view of a company’s financial condition, my favorite financial statement is the balance sheet. Admittedly, balance sheets are not as “sexy” as, say, income statements. However, as we accountants realize, balance sheets capture the potential of a company to generate sales and how the income-generating assets were financed.
The name “balance sheet” grossly understates all the information that is contained therein. Accounting students are so focused on the immutable equation (Assets = Liabilities + Shareholders’ Equity) that they can miss much of the more important information:
The right side reveals how a company is financed (trade payables, debt and equity). Debt is of course a double-edged sword as the cost and term structure can be problematic. Debt financing is less expensive than equity but excessive leverage can also cause issues.
Trade payables reveal half of a company’s working capital as vendors need timely payment.
The left side shows what a company generates income from (inventory)
The left side provides the remaining half of the working capital calculation (cash and receivables). Current assets should always exceed current liabilities, and stale receivables could be a sign of delays with collecting sales receipts.
The stockholders’ equity portion of the balance sheet includes inception to date earnings (or loss) and also year to date earnings (or loss).
In addition to merely looking at the values presented in the balance sheet, let’s delve a bit deeper at the ratios one derives from a balance sheet.
Current ratio – an indication of a company’s liquidity, the current ratio is comprised of the relationship of current assets to current liabilities. Current assets are items of value that can be converted to cash within twelve months. Similarly, one is to repay current or short-term liabilities within one year of incurring them. Ample liquidity means a company can come up with the funds for an unexpected expense without having to borrow. Generally speaking, a current ratio in excess of 1 is deemed to be acceptable.
Current Ratio = Current Assets / Current Liabilities
Quick ratio – another, more conservative measure of a company’s liquidity. Similar to the current ratio, the quick ratio excludes inventory from the numerator. Inventory includes supplies, raw materials, work in process and finished goods. Inventory is not as liquid and therefore overstates a company’s true liquidity. Also, inventory cannot necessarily be converted into cash at its carrying value. A healthy quick ratio is also greater than 1.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Working capital – working capital is the difference between a company’s current assets and current liabilities. The amount of a company’s working capital indicates the ability to meet current obligations (like payroll, trade payables and short-term loan payments). A company has no working capital if their current assets equal (or are less than) their current liabilities. A healthy amount of working capital also shows that one may take on new debt without further reducing its liquidity.
Working Capital = Current Assets – Current Liabilities
Debt-to-equity ratio – one of the various leverage ratios, the debt-to-equity ratio indicates how dependent a business is on debt. Debt-to-equity indicates how much equity is available to cover borrowings. In many industries, a lower ratio is more favorable. However, the ratio is difficult to compare across industry groups because certain businesses (i.e. financial institutions) are far more highly leveraged. Among non-financial entities, higher ratios typically indicate a business with higher risk to shareholders.
Debt-to-equity Ratio = Total Liabilities / Total Shareholder Equity
Solvency ratio - the solvency ratio indicates whether a business has sufficient cashflow to pay off long-term borrowings while also meeting short-term obligations. Tracking a company’s solvency ratio over time can detect potential financial issues. Unlike the other ratios, one needs both the balance sheet and income statement to calculate a business’s solvency ratio. A solvency ratio of 20 percent of more is generally considered to be acceptable.
Solvency Ratio = (Total Net Income + Depreciation) / Total Liabilities
Breakaway advisors not only know how to prepare accurate, timely financial statements but also the “story” they tell. Knowing what powerful, insightful information a balance sheet provides is merely a glimpse of what we at Breakaway provide our clients.
If your business is looking for a powerful financial ally who not only knows how to manage the numbers, but how to use that information to help you meet your goals, reach out. We’d love meet you.
