How financial ratios will help you build solid foundations for your business.
As a business owner you will own lots of assets, owe other businesses money and have shareholders. The balance sheet brings all these together in a financial snapshot showing the businesses financial position at a specific point in time. Together with the Profit and Loss Statement, and Statement of Cash-flow, these reports provide a complete understanding of the financial position and business performance.
In the book “Business for Punks” by James Watts he describes being able to read a Balance Sheet and P&L as one of the five basic financial skills you need to master before starting your own enterprise.
So, what is the balance sheet, what do the different parts means and how can financial ratios help you to measure your company’s performance?
What’s involved? – The balance sheet has three sections: assets, liabilities and equity. (It tells you how much you owe others, and how much others owe you and what has have invested in the company).
The equation is:
Assets = liabilities + equity
For example, if a business has borrowed £10,000 from the bank (a liability) and has had £10,000 invested by its shareholders (shareholder equity), then the business has £20,000 of cash at its disposal (an asset).
What are Assets?
Assets are items and resources that a company owns, anything that is valuable to the business. They have current and/or future value.
Cash in the bank: Most business owners know this number!
Accounts receivable: otherwise known as money owed to your business, this is for services/goods you have delivered but not yet been paid for.
Inventory: stock you can sell
Raw materials: stock the business uses to make items to sell.
Land, buildings, equipment: big capital items that are not quickly turned into cash and are used to run the business.
Intellectual property: intangible items which are hard to quantify including trademarks
What are Liabilities?
Liabilities are amounts owed, so anything that needs to leave the business. This could be to suppliers for goods or services already received or amounts received in advance from your customers for future services yet to be provided by the business.
Bank overdraft: amounts owed by the business to the bank
Interest payable: Interest on loans the business has secured
Salaries for staff: national insurance, tax, PAYE
Tax: HMRC always want their cut (corporation tax)
Loans: Loans from external businesses/lenders (or internal if part of a group set-up)
What is Equity?
The money you’ve put into a business is equity. That includes initial investments you or other investors have made, and earnings you’ve retained in order to reinvest in the future of the business.
Initial Capital: The funds invested into the business when it started
Retained earnings: Income set aside for business purposes and reinvestment into the future
Business owner’s drawing: Money taken out of equity to pay the shareholders.
Shareholders’ equity: The book value of shares held by shareholders
The Balance Sheet Equation
The balance sheet must always balance!
Asset value = liabilities + equity
For example, if you buy a new piece of equipment at £5,000, you pay a £1,000 deposit and take out a £4,000 loan, the value of fixed assets increases by £5k, but the bank asset value decreases by the £1k deposit. The value of liabilities increases by £4k loan, thus leaving the balance sheet balanced on both sides of the equation.
The balance sheet equation shows you how much money you would have left over if you paid all your bills and debts and sold all your assets at a given date. This amount is the Owner’s Equity.
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Reading a balance sheet:
Because of this snapshot nature, it’s important to compare the balance sheet over time, I.e. last month, last year. In terms of reading the balance sheet, there are a number of ratios that can be used to give you greater insight. Ratios can tell you whether your business is built on solid foundations or is unlikely to be able to pay its debts.
Financial ratios are like compressed bits of information that describe your company’s financial health. They describe the health of your business by looking at the relationship between different elements of the balance sheet. By tracking ratios over time can tell you how your business is improving at some things, or where there’s space for it to get better.
So that you can get started straight away let’s go through 3 of the key ratios.
Debt to equity ratio = total liabilities/total shareholder funds
This ratio assesses how reliant your business is on external debt funding compared to equity (shareholder) funding. It is often looked at by investors as they don’t want to be left empty handed.
Generally, 2:1 is acceptable, but it can depend on industry-wide factors. You could compare against similar businesses in the industry. You can ask yourself these questions when considering the ratio:
- Is sales revenue predictable and are invoices being paid?
- Is debt repayment due soon
- Is the business vulnerable if the economy takes a downturn? (I think most businesses will be able to answer this now).
Current Ratio = Current Assets / Current Liabilities
Basically, can your business pay its debts?
A ratio of more than one would mean you could pay all the business current liabilities at once with funds you already have in the business. The business would not need to seek external funds or sell off assets such as stock.
Once you drop below a current ratio of 2:1, liquidity is not looking so good. And if you dip below 1:1, it means you don’t have enough liquidity to pay off your debts.
You can improve your current ratio by either increasing your assets or decreasing your liabilities.
The Quick Ratio = cash + cash equivalents + accounts receivable/current liabilities
How quickly can you cover your short-term liabilities?
If your ratio is 1:1 or better, you can cover current liabilities in a flash.
Balance sheets can tell you a lot of information about your business, and help you plan strategically to make it more liquid, financially stable, and appealing to investors. But unless you use them in tandem with income statements and cash flow statements, you’re only getting part of the picture.
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