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Throughout the recent financial crisis, the strength or weakness of a company’s balance sheet has received more attention.  So how strong is your balance sheet?  Most entrepreneurs do not know, since they focus only on the income statement.  However, creditors and investors will also examine your balance sheet.  If there is one thing that we have learned from this crisis, it is to keep your lenders happy and access to credit available.

Valuations

Before you can assess the strength of a balance sheet, you need to examine the individual line items and understand their valuation.  A key consideration here is that values of many accounts are dependent on assumptions.  Those assumptions are essential for the accountants, but they must be in line with reality.  Accountants value most assets based on historical cost, while investors value them for the wealth they create.  

Accounts receivable (AR) value is dependent on your ability to collect the amounts due.  An AR aging is a tool to assess this since typically the more overdue an account is, the less likely it is going to be collected.  Beyond the aging, are your customers struggling and are their customers paying them in a timely manner?  If your customer is not getting paid, what is the likelihood of you getting paid? 

Inventory is carried at cost, but needs to be assessed in terms of its salability; is it obsolete or have market prices dropped below cost (think commodities)?  In some businesses, spoilage can destroy the value of inventory overnight.  In industries with rapid technological change, obsolescence can occur within months of the product being introduced.  Knowing the underlying physical goods is critical in assessing valuation in these types of businesses.

Fixed assets are carried at cost and are reduced in value on the balance sheet over time via depreciation.  These accounts are the most dependent on assumptions.   Buildings and equipment are depreciated over an estimated economic life, which assumes a certain level of maintenance.  Have they been maintained?  Do these assets really have the remaining economic life that is reflected?   Or has the replacement cost of them changed dramatically?   Have they been made obsolete by technological advances? 

Land is carried at cost for accounting purposes, without any depreciation.   Has the market value of the land you own grown significantly?  Or did you find environmental issues that will decrease its value?

Intangible assets such as patents, trademarks and goodwill arise from the purchase of another business.  These assets are assigned a value when they are purchased for accounting purposes.   The key questions to ask are whether there is real value to an outside purchaser, or do they generate cash on their own?

Liabilities may seem simple, but what if you have payments due based on some contingent event?  Is all of your expected indebtedness accounted for?  Have you provided for vendor invoices that were not received on a timely basis?   Have all taxes incurred, but not paid, been reflected?  Are longer term liabilities, such as pensions, taken into account?

Once you understand the underlying valuations, you can further assess the areas that a balance sheet reveals: liquidity, cash to debt coverage, and leverage.

Understand your balance sheet so that you can look at it the same way your creditors and investors do.   Make them happy and you will increase your financial possibilities.

This article was first published in the January 2010 issue of New Jersey Business.