Balance Sheet Explained

As a manager you can gain a significant amount of knowledge about an organization from understanding the financial information shown in a balance sheet, which can tell you:

• How much it owns - its assets
• How much it owes - its liabilities
• How much equity owners have - its shareholder equity account

If you were investigating Fred's Factory you would be able to see that their total assets are $370,000 and their total liabilities are $309,000, with $61,000 shareholder equity.

In addition to these figures, you will usually want to gain an appreciation of an organization's liquidity and solvency, as well as how its tangible assets compare to its intangible ones.

From the balance sheet you would also be able to perform a common-size analysis, which expresses the figures as percentages to reveal how efficiently the organization is being managed. There are also a variety of financial ratios you can calculate that enable you to assess how well an organization is managing its inventory and receivables.

What a balance sheet tells you

This eBook provides you with an overview of each of these key areas. If you want a more detailed explanation then you should download our free eBook 'Assessing Financial Performance' available from this website.

Liquidity and Solvency

Liquidity and solvency

A key part of your investigation into any organization is to gain understanding of:

Liquidity - the organization's ability to meet its short-term obligations. This includes such items as how much working capital it requires and its debt obligations.

Solvency - the ability of an organization to sustain its activities into the future.

If you wish to assess an organization's liquidity you would use the 'Current Ratio,' which assesses the relationship of its current assets to its current liabilities as defined in the previous sections.

Financial institutions usual require a small organization to have a 2:1 current ratio, but it does depend on the industry sector in question. For instance, a traditional industrial manufacturer will have a lower liquidity ratio than a small retailer.

This 2:1 ratio means that there are twice as many current assets as liabilities. If we look at Fred's Factory his current ratio would be 3:1 and although this represents a good liquidity ratio at first sight you would need to compare to their industry sector before you draw any firm conclusions.

Calculating the current ratio

There is one aspect of the current ratio some analysts are not happy to include in assessing an organization's liquidity and that is 'inventory.' This is because it is difficult to turn inventory into cash. For this reason analysts prefer to use what is known as the 'quick ratio' to measure liquidity.

If you choose to use the quick ratio you would calculate the current assets that are judged to be the easiest to turn into cash (for example, cash on hand, marketable securities, and receivables), which you then divide by current liabilities.

As before, being mindful of the industry your organization operates in is essential, as many sectors can more easily than others turn stock into cash. For example, a sector such as retail can collect its receivables more easily than other industries.

Calculating the quick ratio

The quick ratio for Fred's Factory shows a reduced liquidity ratio because nearly a third of their current assets are accounted for by stock ($44,000).

When you want to assess an organization's solvency you want to see an element of balance between its total debt and the equity used to capitalize it. This shows how well the organization is able to sustain its activities for an extended period in the future.

Defining solvency

The element of 'balance' will vary between different industries as some (for example banks) use debt to finance their activities, whereas a service company is more likely to finance its growth through equity.

Tangible Versus Intangible Assets
The next aspect of the balance sheet you need to assess is the ability an organization has to liquidate an asset. This is achieved by looking at whether or not assets are tangible or intangible.

Tangible Versus Intangible Assets

The definitions of these different types of assets are:

Tangible assets are items that are physical in nature and include cash, inventory, buildings, equipment, and accounts receivable.

Intangible assets are items like patents and trademarks.

In the case of intangible assets you need to take great care as to how you assign a value to them. When one of an organization's key activities is acquiring other organizations there is likely to be considerable 'goodwill' listed on the balance sheet as an asset. This is classified as an intangible asset because if the organization needs access to funds quickly they cannot cash in this goodwill. During the negotiations, if the expected outcome is not attained the buying organization will have to write down the goodwill.

In the case of Fred's Factory, the majority of their assets are tangible because there is no listing of any patents or trademarks. This means that if Fred's needed to they could easily liquidate assets.

There is another key aspect you must look at within the balance sheet when assessing an organization and that is what is referred to as 'other comprehensive income.' This item is recorded in shareholders' equity and results from any income or losses that occur as part of foreign currency conversions.

Due to the nature of such items they are not included in an organization's income statement. Such income occurs where organizations earn revenue in one currency, such as the yen, but never actually convert it to dollars. In terms of assets, whilst the item may show significant sums of money it cannot be relied upon in the event of liquidation, as it may never be realized.

This Key Financial Ratios Checklist details the key financial ratios you can use to help you interpret financial information. This Financial Ratio Formulas Checklist provides you with a list of the most popular financial ratios used to assess an organization's performance, solvency, profitability and investment potential.

You may also be interested in:
Reading a Balance Sheet | Assets, Liabilities, and Equity | Assets Definition | Liabilities Definition | Equity Definition | Common-Size Analysis.

Key Points

  • An organization's balance sheet allows you to determine its liquidity and solvency as well as the ratios of its tangible and intangible assets.
  • You can also use it to determine key ratios like the current ratio and the quick ratio.
  • Assessing the ability of an organization to liquidate its tangible assets will give you an idea of how well it could deal with a liquidity problem.
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