Does my company have a healthy balance sheet?
The balance sheet can be used as an indicator of the health of any company. Picture it as a “scale” that measures the “weight” of a company. If you look closely enough at a company’s balance sheet, you’ll find out how financially strong it really is.
A balance sheet is the financial statement that displays a company’s assets, liabilities, and shareholder equity. Assets can be just about anything owned by the company that can be sold. Liabilities can be loans or other money owed that the company is obligated to pay back. Shareholder equity is total assets minus total liabilities.
With the figures generated from the assets, liabilities and shareholder equity sections on a balance sheet, we can piece together a few key equations that will give helpful insight on the financial health of any given company.
Book Value or Shareholder Equity
It can be powerful for a company to understand its own shareholder equity. This is important to know to better understand what your company is worth if you ever have to jump ship (worst case scenario), or acquire financing. I prefer to call shareholder equity book value, because a lot of small businesses just have one owner. The difference between a company’s assets and liabilities gives you the shareholder equity or book value of the company.
To help you understand a bit better, I’ve put together an example. The company we will use for this example will be referred to as XYZ Inc.
For it’s assets, XYZ Inc has $100,000 in equipment, $250,000 in real property, $50,000 in cash and cash equivalents, $20,000 in accounts receivable, and an $80,000 stake in another company. The total assets of XYZ are worth $500,000.
For it’s liabilities, XYZ Inc has $67,000 in long-term debt (equipment loan), $43,000 in accounts payable, and $10,000 in other current liabilities. The total liabilities of XYZ Inc are worth $120,000.
To get total book value of XYZ Inc, you subtract assets from liabilities ($500,000 – $120,000 = $380,000). XYZ Inc has a positive book value, which is a win. Book value should be positive, though there are companies that get away with a flat or negative book value for a long time.
Though this doesn’t usually apply to private companies, you can use the book value of the company divided by the number of outstanding shares to get the book value share price.
So if XYZ Inc had 1,000,000 shares, you would divide $380,000 by 1,000,000 to get a price per share ($380,000 / 1,000,000 = $0.38).
Price to Book Ratio
Price to book ratio is a popular balance sheet equation used on public companies to determine where the traded price of the company stock is vs the book value share price of the company.
So, if XYZ Inc was publicly traded at $1 per share, and the book value per share was $0.38, you would divide $1 by $0.38 (1 / 0.38 = 2.63). At $1 per share, XYZ is trading 2.63 times over book value.
Quick Ratio
Quick ratio is a balance sheet equation used to determine the short term liquidity of a company. The way a quick ratio is calculated is by adding up all current assets and dividing them by current liabilities.
Current assets would be considered cash and cash equivalents, liquid securities, and accounts receivable.
Current liabilities would be credit card debt, accounts payable, and other current liabilities.
To find the quick ratio for XYZ Inc, we will add up it’s cash and cash equivalents, it’s accounts receivable, and it’s stake in another company (we are assuming these shares are fairly liquid). Then we divide by its accounts payable and other current liabilities. ($150,000 / $53,000 = 2.83).
The quick ratio for XYZ Inc is 2.83. As a general rule of thumb, we always want a company to have a 1.0 quick ratio as a bare minimum, or higher. A 1.0 quick ratio would mean the underlying company could fully pay down all of its current assets at a moments notice, however after doing so there would be nothing left in the bank.
Debt to Equity Ratio
Debt to equity ratio is similar to the quick ratio, but it focuses on total debt and total equity of the underlying company. The question being asked with this ratio is, what kind of financial leverage does this company have? What percentage of this company is operating on debt versus equity in the company. It also tells us out of all book value (shareholder equity) what percentage of it would it take to pay down all debt?
To find debt to equity, we take total liabilities and divide them by the shareholder equity or book value ($120,000 / $380,000 = 0.3126).
So, the debt to equity of XYZ Inc is 0.3126 meaning that it would take 31.26% of the company’s equity to pay down all of it’s debt.
As a rule of thumb, a great debt to equity ratio is anything less that 0.5.
Conclusion
The balance sheet of your company can be difficult to decipher. If you can figure out how to read and analyze it, you will be able to unlock deep insights into the health of your business. Using the equations mentioned above, you can tune your company financially by setting standards to follow. Like I’ve mentioned before, a financial standard for one company may be inappropriate for another. It’s important to set standards that match your appetite for risk as an owner (and other investors).
Resources
For additional insight on financial ratios, visit Investopedia.com.
