The Importance of Understanding the Financial Statement Balance Sheet

Understanding the ins and outs of the financial statement balance sheet can seem daunting. Whether you're a business owner or simply interested in learning more about finances, this guide will provide you with the clarity you need. So let's dive in! 

Balance Sheet in General

If you are like most small business owners, each month you get a “financial statement.” This is really a group of reports designed to give you a report card for your business that typically includes two major sections: a balance sheet and a profit or loss statement. Sometimes included is a detailed ledger that shows the individual transactions that make up the two main reports.

By analyzing these reports, you will gain valuable insights into your business’s financial performance and, hopefully, make informed decisions. While most business owners skip the balance sheet and go right to the profit and loss report, which we understand, there is “gold in dem dar hills” of the balance sheet, so that will be our focus. 

The Balance Sheet in More Detail

One of the key financial reports is the balance sheet. Also known as the statement of assets and liabilities, the balance sheet is a snapshot of what a company owns (assets) and what it owes (liabilities) on a specific date.  

Assets

Assets represent what a company owns. They can be categorized as current assets and non-current. Current assets are highly liquid assets, meaning they can be easily converted into cash within a short time. These include cash, accounts receivable, inventory, and an investment account, if you have one. Non-current assets include investments in machinery, equipment, buildings, and lease deposits.  

Liabilities

Liabilities represent what a company owes. Like assets, liabilities can be divided into current liabilities and non-current liabilities. Current liabilities are short-term debts that are due within a year, such as accounts payable, taxes payable and the portion of a bank loan that will be repaid within 12 months. Long-term liabilities include loans and mortgages that are due beyond a year. 

Why Does the Order Matter?

Accountants order the balance sheet based on liquidity. Assets that are more easily converted into cash are listed first. Cash is considered the most liquid asset, followed by accounts receivable. As you move down the balance sheet, the assets become less liquid. 

The same principle applies to liabilities. Those that are due sooner are listed higher on the balance sheet first. They are typically ordered: accounts payable, credit cards payable, taxes payable and then the short-term portion of notes payable. Long-term loans are listed at the bottom. 

Analyzing the Current Ratio 

Now that you understand the components of a balance sheet, let's talk about the importance of the current ratio (there are many others). To assess a company's financial health, it's crucial to analyze the ratio between current assets and current liabilities. 

A good ratio to aim for is at least three times the amount of current assets to current liabilities, commonly referred to as the current ratio. This means that if a company has $3 in current assets, it should owe no more than $1 in current liabilities. If you have forgotten what current assets are and current liabilities are, please refresh yourself above. 

Why the Ratio Matters

There are two major reasons this ratio is important, and you should know what your current ratio is— 1) When seeking a business loan, banks carefully review financial statements, including the balance sheet. The current ratio is a key factor they consider. 2) Your business needs cushion. 

First, if your company has a weak current ratio, and the bank extends you a loan at all, you will have a higher interest rate, stricter collateral requirements, and other more demanding loan terms. Leaving some financial cushion within the business can strengthen the current ratio and increase the likelihood of receiving better loan terms. 

Second, even more crucially, is what Jim Collins calls “managing above the death line.” At some point, if you have not already experienced it, your business will encounter a significant financial challenge. If you have no financial cushion, your business is more likely to fail than a business with cushion. Your business is likely your biggest source of current income, and your biggest retirement asset. Don’t you owe it to yourself to manage it well? 

Armed with Knowledge

Understanding how to read a financial statement equips you with valuable insights when approaching banks for loans or making financial decisions for your business. When you can confidently navigate financial statements, you can effectively communicate with bankers and address their concerns. This knowledge puts you in a stronger position to negotiate better loan terms and bolster your business's financial stability. 

Building a Three-to-One Current Ratio

Maintaining a three-to-one ratio isn't just about impressing bankers; it's crucial for your business's long-term success. By consistently striving for a strong ratio, you create a solid foundation for growth and weathering uncertainties. 

Consider this an opportunity to set goals and work towards achieving a healthier ratio. Implementing financial strategies and closely monitoring your balance sheet will help you meet your targets and ultimately enhance your business's overall performance. 

Conclusion

Congratulations! You've successfully reached the end of our beginner's guide to understanding the importance of the balance sheet. We hope this blog post has provided you with the clarity and guidance needed to navigate the complex world of finance. Remember, understanding your balance sheet is a valuable skill that can greatly impact your business's financial health and your own decision-making abilities. 

So take the time to analyze your balance sheet, aim for a strong three-to-one ratio, and stay informed about your company's balance sheet. Armed with this knowledge, you'll be well on your way to making sound financial decisions and driving your business towards success! Do you want help finding success in your balance sheet? Click the ‘Let’s Chat’ button to see how we can help put you in the best possible position.