The balance sheet is another of the financial statements which we as investors, managers, operators, and employees should all understand. While the income statement tells us how our business is doing by showing the financial results over a period of time, the balance sheet shows us a snapshot of our business at one point in time.
Balance sheet basics
The financial balances of the business are separated into three categories - assets, liabilities, and equity - and are listed as of a specific date, usually at the end of a month, quarter, or fiscal year.
Assets
Assets are economic resources that are controlled by the business to produce value. Essentially, anything owned or controlled by a company that can be converted to cash is considered an asset of that business. Assets typically are listed according to liquidity, or how fast and easily they can be converted to cash, and are divided into several classes.
Current assets are those assets that are expected to be converted to cash, sold, or consumed within one year. Examples of current assets are accounts receivable and inventory. Fixed assets are those assets that have been purchased for continued and long-term use in earning profit for the business. Typically, these items lose value as they are used, so they are depreciated over their anticipated useful lives. Examples of fixed assets are equipment and buildings. Other assets usually include deposits and intangible assets. Intangible assets lack physical structure, but provide value because they give the business some kind of advantage in the market place. Examples of intangible assets are copyrights, patents, and goodwill.
Liabilities
Liabilities are obligations of the business arising from past transactions or events. These obligations typically are settled with the transfer or use of assets in the future. In other words, liabilities are debts and obligations which represent creditor claims on the company's assets. Liabilities are usually divided into current and long-term liabilities.
Current liabilities are those obligations that are reasonably expected to be paid within one year. These liabilities usually include accounts payable and accrued taxes. Long-term liabilities are debts that are reasonably expected not to be paid within one year. Examples of these liabilities are long-term loans and notes.
Equity
Equity represents the remaining interest in the company's assets (spread among the individual owners of the business) after all liabilities have been paid. One way to understand the concept of equity is to think of the sale of a house with a mortgage. The house itself is the asset. The outstanding balance on the mortgage is the liability. When the house is sold, the mortgage company is the first to be paid from the proceeds. The remaining amount is the equity, which is paid to the former home-owner only after the mortgage company is paid.
The capital accounts in the equity section of your balance sheet show how much money has been contributed to the business by its owners. Retained earnings show how much the business has cumulatively earned since its inception. And last, but certainly not least, the equity section shows how much money the business has returned to its owners in the form of distributions during the life of the business.
The simple formula for the balance sheet is:
Looking at the equation this way tells us how our assets were financed: either by borrowing money (liability) or by using owners' money (equity). Balance sheets usually show assets in one section, and liabilities and equity in the other section, with the two sections balancing.
Balance sheet analysis
So, what should you look for when reviewing your balance sheet? Compare the total current asset balance in relation to the total current liabilities. Even better, compare the sum of cash and receivables to the total current liabilities. This comparison measures the ability of the business to immediately pay its short-term liabilities. In general, the higher the ratio of current assets to current liabilities, the more financially stable the business is. This comparison can be a warning sign if the current asset figure is less than the current liabilities balance.
Another area to take particular notice of is the fixed assets section. How much accumulated depreciation is currently recorded? What is the resulting net book value of the fixed assets? The closer the balance of net fixed assets is to $0, the more likely the business will have to make large expenditures in the near future to replace old equipment, buy new computers, and rehab the facility space.
Yet another important measure on the balance sheet is the comparison of long-term debt to the company's total equity. The higher the debt-to-equity ratio, the more debt leverage the business is using and the higher risk level the business must carry. Having debt on the balance sheet is not necessarily a bad thing. However, as the company's level of debt increases, the business will have to make larger monthly principle and interest payments to the lenders. As this monthly obligation grows, it adds to all of the other monthly expenditures that are necessary to operate the business (i.e., wages, supplies, implants, rent, and insurance). Larger monthly debt payments basically increase the amount of cash needed each month, and thus puts more pressure on the operations of the business to make more money. These debt payments also reduce the funds available for distribution to the business owners.
Knowing the components of your balance sheet and what signs to look for can help you determine the financial strength and well-being of your business. The balance sheet can help tell the story of what has happened in the past and where the business is in the present. Coupled with knowledge of the income statement, understanding the balance sheet can also help us prepare for what is on the horizon, and guide our business decisions in the future. With healthcare reform upon us, the knowledge learned from the balance sheet (and indeed from all of our financial statements) can help us successfully navigate through these uncertain times and help ensure that we will continue to have a strong business for years to come.
Learn more about Regent Surgical Health. Contact Matt Lau at mlau@regentsurgicalhealth.com or (708) 498-4473.