The Basics of Financial Statement Analytics: The Balance Sheet
When a startup begins attaining outside loans, grants or investments, it will likely be required to submit periodic financial statements to its funders. Whether those financial statements are reviewed or audited by an independent accountant or prepared internally through an accounting software such as QuickBooks, it is important for management of the business to understand the fundamentals of the financial statements and how they will likely be used by external parties.
The following is a summary of some common calculations that financial statement users perform when analyzing a business’ balance sheet.
The balance sheet presents a snapshot of a business’ financial position as of a specific date, which will typically be the last day of the month, quarter or fiscal year. It reports the balance of each of the business’ assets, liabilities and overall equity as of that date. Here is an example of what a simple balance sheet might look like:
When preparing a balance sheet, total assets must always equal the sum of total liabilities and equity. Additionally, assets and liabilities must typically be classified into the following two categories:
- Current: expected to be liquidated or paid within one year of the balance sheet date
- Non-current, or Other: not expected to be liquidated or paid within one year
Balance Sheet Analytics
The classification between current and non-current assets and liabilities is critical to understand, as it plays a key role in several common analytics that readers use to evaluate the overall financial health of a business. These include but are not limited to:
- Working Capital: Current Assets less Current Liabilities
- Current Ratio: Current Assets divided by Current Liabilities
Lenders and investors will look more favorably upon businesses with a positive working capital or a current ratio that exceeds 1.0.
The purpose of the above calculations is to evaluate the ability of a business to pay its upcoming obligations. In other words, they are measures of the solvency of a business. Existing and potential lenders and investors will understandably place importance on these calculations. Further, lenders will often include financial covenants in their loan agreements requiring commercial borrowers to maintain a minimum working capital or current ratio. Financial statement preparers must therefore ensure that assets and liabilities are classified appropriately on the balance sheet.
Another common analytic related to the balance sheet is the Debt-to-Equity Ratio. The calculation is simple – Total Liabilities divided by Total Equity. The purpose of this calculation is to understand a business’ financial leverage; i.e. how much of its financing comes from debt versus equity. Businesses will generally be seen as more aggressive or risky as its Debt-to-Equity ratio increases. The ideal Debt-to-Equity ratio will vary depending on the size, nature and industry of the business in question. That said, a typical Debt-to-Equity ratio will generally be between 1.0-2.0.
Management should be reviewing the business’ financials on a regular basis and looking at these same calculations so that they can make the necessary decisions for the overall financial well-being of the business.
