In our previous post, we talked about the balance sheet and how important it is as a tool for understanding the health of your business. Now we’ll take a closer look at how you can better understand that information!
The balance sheet is basically a snapshot of your company’s assets and liabilities at a specific moment in time. It will give you a good idea of where your company is as far as liquidity and health, and looking at multiple balance sheets over time will indicate the direction your company is taking in terms of growth.
What am I Looking At?
As with any financial document, at first glance a balance sheet can be somewhat confusing. Some of the terms may seem familiar, but you may not know what they mean in this context, or what their relationships are to each other. We’ll walk you through each side of the balance sheet and explain the terms used!
The first side of the balance sheet is Assets.
Fixed Assets are long term resources that aren’t likely to change in a hurry, like property and machinery, or even less tangible possessions like intellectual property rights.
Current Assets are your cash on hand, accounts receivable (money owed to the company) or stocks. These items will fluctuate more from year to year.
The second side of the balance sheet is Liabilities, and it’s divided similarly.
Long-Term Liabilities are just that – they’re long term amounts due in more than a year, like bank loans.
Current liabilities are short-term amounts you will owe soon, such as service contracts or bills from the vendors you work with due within a year.
Equity is the accumulated balance of amounts invested in the company combined with past profits.
How can I use this information?
Now that you have an idea what your balance sheet is telling you, you can use that information to look at important factors that affect your business, also known as key performance indicators.
As a team of chartered accountants, CPAs and bookkeepers, we can help you determine which of the below indicators will provide the most useful information for your particular business. By comparing key ratios against the same figures for prior periods and also against other businesses, it can help identify areas where you need to take action.
Return on Equity is your profit before tax, shown as a percentage of what you owe your shareholders.
Return on Equity = Net Income / Shareholder’s Equity
Working Capital is the amount of invested capital it costs to support the day-to-day operations of your business. It is a measure of a company’s efficiency and short-term financial health.
Working Capital = Current Assets – Current Liabilities
Control of Working Capital is how much your current assets relate to your current liabilities. If you needed to pay all your debts tomorrow, would you be able to pull together the resources to do so?
Financial Strength is the amount of money you need to borrow to continue growth. Is most of your growth coming from capital or is it being borrowed?
Return on Capital Employed is important. It’s what your net profit is compared to how much you’re putting into the business. If you have a million invested but are making $50k in profits, that’s a 5% return on your investment. It’s important to know how best to use your money so you can maximize your return!
Capital Employed = Total Assets – Current Liabilities
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) / Capital Employed
Knowing how to interpret your balance sheet is just the start to taking control of your business finances, but it will allow you to have informed discussions with your financial advisors and formulate the right questions. If you would like our help with a business healthcheck, bookkeeping, or reporting, contact us here!