The Balance Sheet and Key Liquidity Ratios
Here it is, the 10th of the month, and your bookkeeper trots into your office, financial statement in hand. She has that big grin on her face—not because she knows whether the news she’s delivering is good or bad, but because she got it to you on time.
And therein lies a trap. Surely, the timeliness of financial information is important. But a shrewd analysis of that timely information is vital as well.
Although your first impulse may be to go straight to the Income Statement to see your bottom line, it’s imperative to examine your Balance Sheet to check your company’s underlying health. Bankers, finance companies and potential investors always look first to your balance sheet. They know the income statement shows a relatively short-term picture of a company—a month, quarter or year—while the balance sheet reflects its history. You can boost revenues or temporarily slash expenses in order to show profits, but that doesn’t necessarily prove long-term sustainability. The balance sheet, however, shows your company’s ability to pay bills and meet obligations. Strong retained earnings indicate ongoing profitability through the years.
So let’s take a closer look at the balance sheet. It includes assets (what you own), liabilities (what you owe) and stockholders’ equity (the sum of your initial investment, your stock and your retained earnings).
Assets and Liabilities
Assets include cash, accounts receivable, inventory, store fixtures and improvements, real estate owned, vehicles and any marketable securities. There are two types of assets: current and fixed. Current assets are those which you will probably turn into cash within the coming year—cash, inventory, accounts receivable, pre-paid expenses and short-term securities. Fixed assets are those you purchase to use in the operation of your business and that you keep for a longer period, like computers, fixtures and trucks.
If you want to derive useful information for managing your business, be honest with yourself when it comes to assets. Remember that receiver in the back that you’ve used for scavenging parts, or the monitor you took back after it had been in a customer’s home for six months? Should they really be included in your inventory?