How can we help strengthen your business?

How can we help strengthen your business?

Get a strong understanding of your balance sheet, and learn 3 financial ratios for deeper business acumen

The balance sheet offers critical insight into the health of a business that can be useful to various interested parties, such as potential investors weighing a decision to invest your a company

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When it comes to understanding a business, there are few financial statements more important than understanding your balance sheet. The balance sheet offers critical insight into the health of a business that can be useful to various interested parties:

  • Potential investors weighing a decision to invest your a company
  • You business owners to craft more effective organizational strategy
  • Employees to adjust their processes to better reach shared organizational goals 

Whether you’re a business owner, employee, or investor, understanding how to read and understand the information in a balance sheet is an essential financial accounting skill to have.

Here’s everything you need to know about understanding a balance sheet, including what it is, the information it contains, why it’s so important, and the underlying mechanics of how it works.

Understanding your balance sheet: What exactly does a balance sheet do?

A balance sheet serves the purpose of providing an overall view of a business’s financial position at a specific point in time. It informs the business owner of the company’s financial health, which can be the source for taking informed strategic and operational business decisions. Other users could be financial institutions for purposes of either lending the company capital or potential funders for an investment. Also called the statement of financial position, the balance sheet assists stakeholders with risk assessment. Because it shows all the assets and liabilities that belong to the company, the solvency and liquidity of the company lie on this financial statement. Liquidity risk can occur when the entity cannot meet its short-term debts, in other words, when its current liabilities exceed the current assets. While solvency risk is the risk that the entity might not be able to meet its financial obligations, even after disposing of their assets.

The balance sheet consists of three sections, and we will briefly break down each of them, followed by Kettle’s approach on strengthening this financial statement.

Understanding your balance sheet: What are Assets?

IFRS defines an asset as “a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity”. To simplify the term, it may be defined as a resource with economic value that an entity owns or controls.

Assets can be further broken down into short-term and long-term assets:

your balance sheet

Understanding your balance sheet: What are Liabilities?

Formerly defined as, “a present obligation of the entity as a result of past events and from which future economic benefits are expected to flow from the entity”, a liability is an obligation of money or service owed to another party.

Similar to assets, liabilities are broken down according to the period that they are expected to be settled, being current (short-term) and non-current (long-term):

Understanding your balance sheet: What is Owner's Equity?

Owner’s equity is the proportion of the total value of a company’s assets that can be claimed by its’ owners and shareholders. The balance sheet equation states: Assets = Liabilities + Owner’s Equity.

The balance sheet equation shows the residual value due attributable to equity holders after all liabilities have been offset on a given date. Note that the balance sheet equity total is not necessarily how much the business is worth at market value.

your balance sheet 3

Understanding your balance sheet: Financial Ratios

The liquidity and solvency of the organization can be derived from its balance sheet. These ratios can be used to assess the financial health of the company and can better inform an investment decision. As an investor, you would be concerned about the borrower’s ability to service short term liabilities (liquidity), as well as its longer-term liabilities (solvency).

Liquidity ratios – Liquidity ratios measure how quickly a firm can pay off its short-term liabilities by liquidating short-term assets or a variation thereof (e.g. using cash). The most common are the current and quick ratios. A company should have at least current liabilities equal to their current assets, which is a current ratio of 1. A ratio of 1 means that the company can pay off all its current liabilities with its current assets. A ratio of less than 1 would mean that the company has more current liabilities than they do current assets, and would therefore not be able to meet their short-term liabilities using their short-term assets.

Creditors use liquidity ratios to determine a company’s credit worthiness, while investors use them to determine its investment worthiness.

Current ratio = Current assets/ Current liabilities
Quick ratio = (Current assets – Inventory)/ Current liabilities

Solvency ratios – Solvency ratios are used to figure out how well a company is positioned to pay off its debts. The current and quick ratios can be used for both liquidity and solvency tests. The debt-to-equity ratio shows how much debt a company has, compared to its equity. While the interest coverage ratio is used to determine whether a company can pay its interest expenses.

Debt to equity ratio = Debt outstanding/ Equity

A higher ratio, especially above 1.0, indicates that a company is significantly funded by debt and may have difficulty meetings its obligations.

Interest coverage ratio = Earnings before interest and tax/ Interest expenses

The higher the ratio, the better. If the ratio falls to 1.5 or below, it may indicate that a company will have difficulty meeting the interest on its debts.

Efficiency ratios – Efficiency ratios measure a company’s ability to use its assets to generate income. An improvement in these ratios translates to improved profitability. The return on equity (ROE) shows how well a company is managing the capital that shareholders have invested in it. The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity financing. Return on assets ratio (ROA) is used by investors to determine how efficiently a company uses its assets to generate a profit. A higher ROA means a company is more efficient and productive at managing its balance sheet to generate profits, while a lower ROA indicates there is room for improvement.

Return on equity = Net Income/ Shareholder’s equity
Return on assets = Net Income/ Total Assets

Assets are listed on the balance sheet at their transaction value, which may be very different from the market value. Some assets may be worth more, and others may depreciate. Business value is calculated not just on the balance sheet figures but on many other factors.

Talk to us to get a complete picture of your business performance and financial position, regardless of what stage of business you are at. You may email us at info@kettleconsulting.co.za or call 011 025 1446 (Johannesburg) and 021 003 8000 (Cape Town)

Understanding your balance sheet: What exactly does a balance sheet do?

Insight by:

Puleng Malakoane

Management Consultant

Kettle Consulting (PTY) Ltd

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