You are probably somewhat familiar with Global Positional System devices.  Among the many uses, one takes the form of a nifty little device for determining one’s location or providing directions from point A to point B.  In my last article I suggested that there are similarities between a GPS and a businesses financials.  In that article, I presented a brief overview of each of the three financial statements.  This article will dig a little deeper into the Balance Sheet.

I often find that business owners largely ignore the Balance Sheet or give it a cursory review, instead favoring the Income Statement.  When I would inquire of owners as to why, the response was generally along the lines that they didn’t see much value in the Balance Sheet.  While some might not agree, I believe the Balance Sheet to be the most important of the financial statements.  The Income Statement is really a subset of the Equity account on the Balance Sheet and the Cash Flow statement reflects the difference between two different Balance Sheet snapshots in time.  Both revolve around the Balance Sheet.

As the earlier article described the organization of the Balance Sheet, this article will focus on the kinds of information that can be derived from review of the Balance Sheet.  Review may take the form of ratios, simple subtractions or monitoring trends over time and provides an indication of the use of operations, financing and investment dollars.  As space limits the depth of discussion, a future article will delve into the details of financial statement analysis.  

Indications of Liquidity:  Liquidity refers to the ability of a business to meet the demands for cash on a short-term basis. It compares the current portion of what the business owns (operating assets) relative to what the business owes (operating liabilities).  Obviously it is better for the business to own more than it owes and the larger the difference the more satisfactory the measure.  Most liquid are cash and cash equivalents.  Least liquid is inventory. Indications of Solvency:  Solvency is similar to liquidity but looks at the long-term perspective of the businesses' ability to raise funds to pay its debts and provide for sustained growth.   While liquidity measures focus on the operating aspect of the business, solvency measures involve relationships among fixed assets, long-term debt, equity and aspects of return on those investments.  For instance, a comparison between long-term debt and equity is an indication of who really owns the business, lenders or the business owner.

Investment in Fixed Assets:  The extent of capital investment (land, bricks and mortar and equipment) varies considerably among industries.  An equipment manufacturing plant will have a much greater investment in a physical plant than service business such as a restaurant.  I have seen many startups sink all their capital into the fixed assets part of their business only to find they don’t have enough cash to operate the business until a customer base is grown.

Working Capital Availability:  While important, fixed assets alone will not result in sales.  Business must have sufficient working capital to cover operation activities such as purchase of raw materials, attracting a labor force and producing a marketable product.  While the difference between current assets and current liabilities is the amount of working capital, the difference in the amount of investment in short-term assets verses long-term assets is important as well.  Too much investment in the physical plant may jeopardize the ability of the business to meet the cash requirements of operating the business on a daily basis.  

Financing of the business:  A business can be financed either through the contributions of the owners or by borrowing from lenders.  The relationship between theses two sources of funds should be continually evaluated.  Rare is the business that doesn’t use debt at some point.  As a rule of thumb, short-term debt should be used for short-term purposes and long-term debt for long-term purposes.  Businesses can get into trouble when they mix the type of debt with a different purpose.  Financing the purchase of equipment (long-term purpose) with short-term money (under a year) may constrain cash needed for operations and could place the business at risk in repaying the loan.  Financing the day-to-day operations of the business with long-term debt is an equally poor practice as capitalizing operations distorts the cost of producing the product or providing the service.  The true cost of production doesn’t flow to the income statement at the time the product is sold.   

The Balance Sheet is a great source of information for those who care to examine the contents of this financial.  This article has examined some of the different ways that information can be used.  Like the GPS, the balance sheet provides a snapshot of position at a point in time.  For an owner, it is an indication of the financial position of the business.