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How to Effectively Analyze a Balance Sheet

posted by: Scott Hislop
Oct 2, 2017 9:12:00 AM

Among the most valuable tools for determining the value of a businessis its balance sheet. It can reveal some very telling information about the company if you know what to look for.

What follows are just a few of the basics to help you analyze a balance sheet.  

What Is a Balance Sheet?

A balance sheet provides an accurate representation of a company's financial position at a specific point in time. It details the value of the company's assets as well as its liabilities.

Assets

Assets are divided into two categories: current assets, which can be converted into cash relatively quickly; and fixed assets. Items such as cash, stocks and bonds, accounts receivable, inventory, and HOW TO EFFECTIVELY ANALYZE A BALANCE SHEET transworld minnesotaprepaid expenses make up a company's current assets.

Fixed assets are assets that are used to generate revenue. They can include furniture, vehicles, real estate, machinery, equipment, and any other item used in the business whose usefulness can be measured in years. All fixed assets, with the exception of land, should appear on the balance sheet at its original cost minus any depreciation. This avoids possible overvaluation by subtracting a specific amount from the original cost to account for wear.

Liabilities

Much like assets, liabilities fall into two distinct categories: current liabilities and long-term liabilities. Current liabilities include accounts payable, notes payable (monies due on loans during the next 12 months), and accrued payroll taxes. Long-term liabilities are any debts that are repayable a year or more after the date of the balance sheet. It can include loans, financing, and mortgages.

How to Analyze a Balance Sheet

From the data, you can analyze the balance sheet to start painting a picture of the company's value.

Net Worth

The net worth looks at what's left after all of the liabilities are subtracted from the total amount of the company's assets. If the company owes more than it has in its assets, the net worth will appear as a negative figure.

The Current Ratio

Used as a means to help measure the company's financial strength and solvency by showing the number of times current assets are greater than current liabilities, the current ratio is calculated by dividing the total current assets by the total current liabilities. A low current ratio could suggest that the company may have trouble meeting the payment schedules of its current liabilities.

The Quick Ratio

The quick ratio looks at a company's liquidity by measuring its most liquid assets (those that can be turned into cash the fastest) in relation to its current liabilities. Calculated by dividing the total current assets excluding inventory by the current liabilities, the quick ratio helps to show the business could meet its obligations under adverse conditions. As a rule of thumb, a quick ratio between .50 and 1 is generally considered acceptable.

Working Capital

As you may have guessed from the name, working capital shows how much money the business has available to work with at any given time. To determine the working capital, subtract total current liabilities from total current assets. This too is a measure of the company's liquidity, and financing terms may require that a certain level of working capital be maintained at all times.

As useful as analyzing a balance sheet is, it's important to remember that there is more to evaluating a business. A balance sheet doesn't offer a perspective on trends and progress. For that, you’ll want to compare the current balance sheet to previous ones and look at cash flow statements.

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