Balance sheets are one of the three key financial documents, along with income statements and cash flow statements. Balance sheets help a company understand their financial position at a given point in time. This differs from income and cash flow statements, which are both calculated over a period of time. At its core, a balance sheet tells you the risk of your venture.
Let’s dive in:
The Equation
Assets = Liabilities + Owner’s Equity
1. Assets
There are two kinds of assets:
Current Assets: These are all your assets that can be converted into cash within 12 months. This includes current cash (from income statement), accounts receivable, inventory, etc.
Other Assets: This covers assets that will be held for a longer period of time. Some examples are property (office space), manufacturing plants, equipment, and such.
Assets are anything that you own.
2. Liabilities
Similar to assets, there are two kinds of liabilities:
Current Liabilities: These are liabilities that must be fulfilled within 12 months. Some examples include accounts payable, accrued expenses, deferred revenue
Note: accounts payable are formal expenses with invoices (invoice for raw materials, inventory), while accrued expenses are estimates of other expenses (salaries, interest on debt, utilities)
Noncurrent Liabilities: Liabilities that are not expected to be paid within 12 months. Ex: long-term debt, lease obligations, deferred tax liabilities.
Liabilities are anything you owe.
3. Owner’s Equity
Owner’s Equity is calculated by flipping the equation we had above:
Owner’s Equity = Assets - Liabilities
This helps value the company, so shareholders understand how much their equity is worth. Always make sure that this equation adds up, if it does not there is an error in your balance sheet.
Below is an example of a past balance sheet from Apple.
Financial Health from Balance Sheet
With the basics down, now we can use our balance sheet to understand the strengths and weaknesses of the business. Here is some tools and metrics that help us do that.
Aging Schedule
The hardest part of filling out your balance sheet is understanding how fast money is coming in or going out. An aging schedule is a simple timeline of when accounts receivable has money coming in, or when accounts payable has money due. This helps calculate two key metrics that quantify these principles.
Days Sales Outstanding (DSO): How long it takes to convert sales to cash. The formula for this is:
DSO = Average Accounts Receivable / Revenue * Period of Time
High Accounts Receivable relative to Revenue indicates that there are issues converting sales to cash, while lower AR relative to Revenue indicates quick sales turnarounds that convert to cash easily.
Days Payable Outstanding (DPO): Time it takes to pay vendors. The formula is:
DPO = Average Accounts Payable / Cost of Goods Sold (COGS) * Period of Time
To the contrary of DSO, high DPO is better for business. Larger accounts payable means that payments are spread over a larger period of time, providing the business with more cash on hand to spend on other long term investments.
The concept of an aging schedule can also be used for understanding interest, depreciation, and general pricing for Noncurrent/Other Assets as well as Noncurrent Liabilities. Good rule of thumb is always understanding how each of your assets/liabilities will change in price over time, not just at the time of sale.
Debt to Equity Ratio
D/E Ratio = Total Liabilities / Total Shareholders’ Equity
A good debt to equity ratio is between 1-1.5, anything higher either indicates that the company is relatively in a growth phase or in distress. A high D/E ratio indicates a higher risk venture. A company that is relying on debt financing is not as stable as a company that raises through giving up shareholder equity. Heavy reliance on borrowed money is not ideal.
Interest Coverage Ratio
The interest coverage ratio indicates how many times a company can cover its interest payments with its earnings from a given period. The formula:
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
As long as the ratio is greater than 1, your business will stay afloat. The greater the ratio, the safer you will be from defaulting.
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