Balance sheet analysis

When valuating a business, the analysis of the financial statements helps to understand its evolution. To understand the financial performance of a business, access to up to date financial statements is useful. Financial statements are the consolidation of financial information of a business. To understand the various financial statements, it is important to know what is contained in them. In this article, we will discuss the balance sheet and key ratios that are important to know.

Financial information is useful for appraising a business, but also when the owner plans to sell or when a potential buyer demonstrates an interest. If you want to learn about the importance of financial information when selling a business, I invite you to read on the importance of financial information at the sale of a business.

The balance sheet

The balance sheet provides a picture of a business at a given date.

The report indicates everything the business owns and what it owes. You will find the assets, the liabilities and the owners’ equity. Assets and liabilities are separated between short and long term.  “Short-term” assets stand for amounts that will or can be converted into cash within the next year, for example:

• Cash
• Accounts receivables
• Inventory (stock value);

“Short-term” liabilities are debts that must be paid within twelve months, for example:

• Accounts payables
• Income taxes payable;
• Capital payable, during the next twelve months, on a long-term loan.

“Long-term” assets are the ones that will not be converted into cash within the next year, for example:

• Investments in private companies’ shares;
• Capital assets (eg, equipment and real estate properties).

Regarding “long-term” liabilities, these are debts that will not be paid within the next twelve months (the portion to be paid in the next year are included in short-term liabilities), for example:

• Mortgage
• Car loan
• Due to shareholders;
• Due to other corporations.

The balance sheet contains a section for equity, also called capital, belonging to the business owners or shareholders. Equity is the difference between assets and liabilities. For example, for an incorporated business it will include the initial investment paid in the form of share capital and the net profits earned by the company over the years and not distributed to the shareholders. If the business has accumulated losses, this amount can be negative.

The short-term assets and short term liabilities are usually at the market value.  The long-term assets and liabilities are stated at cost. In the case of capital assets, the acquisition cost will be reduced by accumulated depreciation thereon. In the case of real estate properties there may be a significant gap between its fair market value and the value stated in the balance sheet.

Key ratios of the balance sheet that we should know

The numbers on a balance sheet can be studied in various ways. For every industry it is possible to find ratios that permit the comparison of the business to its industry. Is my business comparable to its the industry? Is the business doing better or worse than others in the same industry?

The two key ratios we need to know are: the liquidity ratio and the debt ratio.

The liquidity ratio or working capital ratio (Current assets ÷ current liabilities).

This ratio indicates whether the business has sufficient working capital to cover its short-term liabilities. If the industry ratio is unavailable, a good ratio to aim for would be 2:1. This means that the company has two times more current assets than current liabilities. However, it is important to be careful in this calculation as a business with a large inventory could have a liquidity ratio 2:1, but have an inventory management problem. A variation of this ratio would be to use the same calculation, but removing the inventory from the current assets.  We call this ratio, the quick liquidity ratio.

The debt ratio (total liabilities (short term and long term) ÷ equity)

Again, there are databases that provide information on businesses in the same industry. For example, if this data is not available for a business that does not have real estate property, a ratio of 2:1 may be reasonable. In the case of a business that has bought real estate recently, the debt ratio could be very high. This does not mean that the business is drowning in debt. This is why it is important to analyze deeper. It is not enough to stick to the numbers.

It may be interesting to watch the evolution of these two ratios from year to year. This is a good way to see if there is an improvement. And, if this is not the case, to take steps to rectify the situation.

In short, for a business owner, the financial statements turn out to be an excellent management tool. Ideally, they would be produced regularly to ensure close monitoring of operations. Financial statements produced monthly can also be useful to prepare budget projections for the business.  In addition, many conclusions can be drawn from the figures in the balance sheet. It is therefore possible for a Chartered Business Valuator to have a clearer picture of the business.  The analysis can also identify some of the strengths and weaknesses of the business, and propose strategies to improve performance.

If you have questions about these ratios or on the performance of your business, contact me. With my partners, I will be happy to support you in achieving your goals.