Learn to dissect your company’s balance sheet to discover opportunities for growth, imminent shortfalls, financial disasters in the making, and trends both favorable and unfavorable. To jumpstart your analysis, focus on the following key indicators.
Current ratio. The current ratio is calculated by dividing current assets by current liabilities. Current assets generally include cash, investments, short-term accounts receivable, inventory, and supplies. Current liabilities include payroll and other short-term payables, as well as current payments on long-term debts such as mortgages or bank loans. These accounts are classified as “current” because you generally expect to convert them to cash or pay them off within a year or during the current business cycle. For example, you might buy inventory on credit and plan to pay suppliers using proceeds from current sales. The rule of thumb: If your company’s current ratio is greater than one, you have enough short-term assets to cover short-term obligations. If the number dips below one, your business may be headed for trouble.
On the other hand, if the current ratio is three or above, you could be neglecting profitable investment opportunities. For instance, you might have too much money sitting in a low-interest bank account when the funds could be used to develop a new product line, liquidate long-term debt, or invest in a more lucrative venture.
Working capital. Subtract current liabilities from current assets to arrive at this number. Like the current ratio, working capital indicates whether your company has enough cash (and short-term assets that can be converted to cash) to meet current obligations. Banks analyze this number because they’re reluctant to loan money to a business that’s barely covering existing commitments. The greater the amount of working capital, the more likely your company will make payments when due.
Debt-to-equity ratio. You can calculate the debt-to-equity ratio by dividing total liabilities by total equity (assets minus liabilities). The debt-to-equity ratio indicates whether your company is relying excessively on debt to finance current operations. Like the spendthrift who finances an extravagant lifestyle with credit cards, a business that’s heavily leveraged may find itself careening toward bankruptcy. Analyzing this ratio can help you make needed corrections before it’s too late. Generally speaking, the lower the percentage, the stronger your company’s financial health.
If you need further explanation or analyzing your company’s financial statements is stressing you out, give us a call. We’re here so that you can relax!