How's Your Balance Sheet?
Are you comfortable with where your assets and liabilities stand?
DAVID MILLS, O.D., M.B.A.
An understanding of a balance sheet and the liquidity of your business is crucial to your long-term success. As we approach the end of the current fiscal year, now is the time to discuss the liquidity measure of your business with your financial advisors or accountants to help ensure a “financially healthy” 2014.
Here's what you need to know about reading and analyzing a balance sheet.
Reading the balance sheet
The left side of the balance sheet lists the current and fixed assets of your business. Current assets, such as the cash account and inventory, can be converted into cash or sold within your business cycle, but never greater than one year. Fixed assets are typically long-term investments, such as equipment.
The right side of the balance sheet contains current and long-term liabilities, as well as the value of your equity. Current liabilities reflect the amount of debt due in the current year, while long-term liabilities reflect the remainder of debt owed. Owner's equity, or net worth of the business, shows the value of the owner's assets free of debt. The total mathematical values of the balance sheet's left side must equal the right's total.
Analyzing the balance sheet
Loaning institutions rely heavily on balance sheet analysis to determine whether a business is financially capable of meeting its debt obligations, known as liquidity.
Here are some of the key metrics to determine how well your business can pay its debts as they come due:
▸ Working capital. If the value of the working capital (current assets minus current liabilities) is too little or negative, your business may have difficulty paying its creditors on time. If the value is too high, it may be a sign that you are not investing generated profits back into the business.
▸ Current ratio. By calculating the current ratio (current assets divided by current liabilities), the liquidity of businesses of different sizes can be compared. (Because it is a specific dollar amount, the value of the working capital can sometimes be misleading.) The amount of working capital a large corporation needs is not similar to most optometric practices. Most creditors and investors desire a ratio of 2:1 for all businesses, meaning the business has twice the value of current assets to currently owed liabilities.
▸ Quick ratio. Also referred to as the “acid test,” this is similar to current ratio, but uses the most liquid of the current assets, typically the value of the cash account, accounts receivables and any investments on which the company expects to liquidate or receive dividends during the current period. Since the value of the inventory is excluded, the revised calculation of the current assets is lower.
A healthy expected quick ratio is 1:1 (current assets to current liabilities). This ratio is important, as working capital and current ratio do not reflect the composition of current assets or liabilities.
Drive to success
Analyzing your business' balance sheet is similar to looking under the hood of your car to see how your engine is running. A proper analysis of your balance sheet holds the keys to the financial health of your business. OM
DR. MILLS PRACTICES AT OCEAN STATE EYE CARE IN WARWICK, R.I., AND HOLDS A M.B.A. FROM PROVIDENCE COLLEGE. E-MAIL HIM AT MILLSD@NECO.EDU, OR SEND COMMENTS TO OPTOMETRICMANAGEMENT@GMAIL.COM.