In the first financial blog post, I explained the steps of creating a business financial plan. The second post gave insight on break-even analysis. This post will introduce the series: Fundamentals of Analyzing Financial Statements. No matter how big or small a business is, financial statements are essential to tracking financial performance. It is highly recommended to perform a monthly financial review. There are four main financial statements: balance sheet, income statement, cash flow statement, and owner’s/shareholders’ equity.
Let’s start with the Balance Sheet!
The balance sheet contains assets (what you own) and liabilities (what you owe), as well as owner’s/shareholders’ equity. The balance sheet is complemented by the income statement and cash flow statement. They all work in tandem. Here are a few business-related questions a balance sheet can answer:
1. What is the balance in the bank?
2. What cost of inventory is left on hand?
3. Has all of the prepaid expenses amortized?
4. What amount of money is owed to the business?
5. Does the business have any outstanding bills?
6. What amount of debt is owed?
Accounting equation: Assets = Liabilities + Owner’s/Shareholders’ Equity
The following ratios can assist with measuring financial performance utilizing items
listed on the balance sheet:
The current ratio measures the business’s ability to cover its debt.
Calculation: current assets / current liabilities
In accounting, current or short-term means one year or less. A current asset is an asset that is expected to be converted to cash within one year while a current liability is a financial obligation due within one year.
Examples of current assets are: cash, accounts receivable, or inventory.
Examples of current liabilities are: short-term debt, notes payable, or dividends.
The aim is for the current ratio to be above 1. A current ratio below 1 implies that the
business may not be able to pay its debt when it becomes due.
The quick ratio is a modification of the current ratio. The highlighted difference is that the current ratio takes all of the business’s current assets into consideration, whereas, the quick ratio only considers the cash on hand and accounts receivable (money owed to the business by customers).
Calculation: Cash + Accounts Receivable / Current Liabilities
Similarly to the current ratio, the objective is to have a quick ratio of 1 or higher.
This ratio compares a business’s total liabilities to its owner’s/shareholders’ equity and
monitors the company’s debt against its net assets.
Calculation: Total liabilities / Total Shareholders’ Equity
Ideally, a debt-to-equity ratio of 1 or higher is good. However, the benchmark for this ratio varies per industry. There are various ratios to measure a business’s financial performance; however, the above-mentioned are applicable when using the balance sheet. Next in the series, I will explain how to measure a business’s performance using an income statement.