Can you read a balance sheet? A short guide for owners

Most owners look at the profit and loss account: how much revenue, how much cost, what was left. They sign the balance sheet and pass it to the bank. Yet it is from the balance sheet that a bank, a buyer and an auditor conclude how stable the company is. It pays to know what they see in it.

What a balance sheet shows

The profit and loss account is a film: what happened during the year. The balance sheet is a photograph: the position on one day, usually 31 December.

It has two sides that are always equal.

Assets show what the company has:

• Non-current assets: land, buildings, machinery, vehicles, software, stakes in other companies.
• Current assets: stock, trade receivables, cash.

Equity and liabilities show how it was paid for:

• Equity: what the owners put in and the profit that stayed in the company.
• Non-current liabilities: loans and leases due in more than a year.
• Current liabilities: suppliers, salaries, taxes, short-term loans and the part of long-term loans due within the next year.

Everything the company has was financed by someone: owners or creditors. That is why the two sides are equal.

Five questions a balance sheet answers

1. Can the company pay what falls due soon?

Compare current assets with current liabilities. The ratio is called the current ratio.

If current assets are EUR 800,000 and current liabilities EUR 500,000, the ratio is 1.6. A rule of thumb says above 1.5 is comfortable and below 1 is a warning, because the company is then financing non-current assets with short-term liabilities.

Also look at what current assets consist of. Stock that does not sell and receivables that are not collected are assets on paper, and in reality they pay no bills.

2. How indebted is the company?

Divide total liabilities by total assets. If liabilities are EUR 1,400,000 and assets EUR 2,000,000, creditors finance seventy per cent of the assets.

There is no single right number, because it differs by industry. The higher the share, the more sensitive the company is to a fall in revenue and a rise in interest rates, and the more cautious the bank.

3. Is the equity real?

Equity is the difference between assets and liabilities. It is worth as much as the assets behind it.

If assets include receivables from a customer in bankruptcy, stock that no longer exists or loans to the owner that will not be repaid, equity is overstated by that amount.

Look in particular for a loss exceeding equity. When it appears, liabilities are greater than assets and the company is over-indebted, which also has legal consequences for management.

4. Where is the cash tied up?

Profit and cash are not the same. A company can have profit and an empty account, because the cash is tied up in:

• receivables: goods have been delivered and revenue posted, but the customer has not yet paid
• stock: material and goods have been paid for but not yet sold

If receivables and stock grow faster than revenue, the company keeps more and more cash outside its account. That is a common cause of illiquidity in growing companies.

5. What has changed since last year?

One balance sheet says little. Two side by side say a lot. A balance sheet always has a column for the previous year, so use it:

• Stock is up 40%, revenue 5%. Why?
• Trade payables have doubled. Are you paying more slowly because you have no cash?
• Short-term loans grow year after year. Is ordinary business being financed by borrowing?

A small example

Assets	EUR	Equity and liabilities	EUR
Non-current assets	1,200,000	Equity	600,000
Stock	350,000	Non-current liabilities	900,000
Receivables	400,000	Current liabilities	500,000
Cash	50,000
Total	2,000,000	Total	2,000,000

What can be seen from this:

• Current ratio: 800,000 / 500,000 = 1.6. Fine at first glance.
• There is little cash: EUR 50,000 against EUR 500,000 of current liabilities. Everything depends on receivables being collected on time.
• Indebtedness: 1,400,000 / 2,000,000 = 70%.
• Non-current assets are covered by long-term sources: equity and non-current liabilities together are EUR 1,500,000, more than the EUR 1,200,000 of non-current assets. That is a healthy relationship.

The company is not in trouble, but it is sensitive: one large customer paying two months late would leave it unable to pay suppliers.

What a balance sheet does not show

• The market value of assets. A building bought twenty years ago is carried at cost less depreciation and may be worth several times more.
• What has not been posted. Guarantees given to others, court disputes, contracted commitments.
• What happened between two dates. A balance sheet at 31 December can look good because a loan was repaid on 30 December and drawn again on 2 January.
• The quality of the items. The amount of receivables does not say how many are a year old.
• The value of the company. We cover that in the article on how a company is valued.

What it is for in practice

• Before talking to the bank. The bank will calculate the same ratios. It is better to know them before it does.
• Before a larger investment. Whether the balance sheet can carry it, and how to finance it so that the maturities of sources and assets match.
• With a new customer or supplier. Balance sheets are publicly available. Five minutes of review before granting payment terms can save an uncollectable invoice.
• Once a month, for yourself. The balance sheet does not have to be looked at only at year-end. With the five numbers from the article on controlling, it gives the full picture.

If you would like us to read your statements with you and tell you what we see in them, that is part of financial analysis and controlling. Get in touch.