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A balance sheet is very much like a snapshot. It’s a picture taken at a particular point in time and profiles the company’s assets, liabilities, and the owner’s equity. It’s expressed as of a particular date, usually the end of the fiscal year. Most small businesses use the calendar year as the fiscal year; however, choosing another date often makes things easier and less expensive. For example, if a company’s shipments are highly seasonal, the low point in the inventory cycle would be a logical point to end the fiscal year because the time required to count inventory is minimal.

Essentially, the balance sheet illustrates a fundamental accounting equation: Assets = Liabilities + Stockholder’s Equity.

The first half of the balance sheet records the company’s assets. The second half lists the liabilities and the stockholder’s equity. Notice the analogy to a child’s seesaw, thus the term balance sheet.

Refer to the following examples of balance sheets. Under assets you’ll notice several subgroups. The subgroup listed as current assets (also called short-term assets) refers to cash on hand and to assets that can be converted to cash within one year.

There are also subgroups under liabilities. The first subgroup, balancing current assets, is current liabilities. Current liabilities are short-term debts that must be paid within one year. Two common examples of current liabilities are accounts payable and bank lines of credit.

The difference between current assets and current liabilities gives you a picture of the company’s cash position, or liquidity. This is the working capital that every company needs to manage cash flow effectively. It literally makes the difference between success and failure. A company without enough liquidity does not have enough cast to pay its bills and is in deep trouble.

Smart business owners, however, keep actual cash to an absolute minimum, putting the excess into short-term investments that earn interest. Cash just sitting in the company checking account is not making money for the company.

After cash and short-term investments, the next most liquid asset is the accounts receivable. Accounts receivable are also considered current assets. When you look at your target company’s balance sheet, add the following: cash, short-term investments, and accounts receivable. That sum is what accountants call quick assets. Quick assets can be converted in to cash relatively fast. They are another indicator of a company’s financial health.

Often it’s more useful to express the quick assets as a ration, called a Quick Ratio. By using a ratio, you can compare your target company with the industry average. To get the Quick Ratio, divide the most liquid assets (that is, cash, short-term securities, and accounts receivable) by the current liabilities. The rule of thumb is that a ratio of 1 to 1 is the acceptable minimum, but we suggest that you aim for 2 to 1 to give yourself a good cushion. Since business life is unpredictable, a company with the ability to raise cash in a hurry can more readily weather the inevitable storms that may hit any business from time to time.

Now divide the total of current assets by the total of current liabilities. The resulting number is called the Current Ratio. This is a measure of the company’s liquidity, or, in other words, its ability to meet short-term obligations. A ratio above 2 to 1 is considered strong. If the number is negative, watch out! There may be some exceptions to this, which your accountant can point out. But generally, the Current Ratio tells you a great deal about the financial strength.

Keep in mind that all this talk about liquidity is not idle chatter or a pointless, abstract exercise. Small companies simply can’t afford to make big mistakes and just write them off. Failure to control liquidity can bring on bankruptcy in a flash.

Long-term assets are those holdings that would take ore than one year to convert into cash. They, like short-term assets, are broken down into subgroups. Long-term assets are fixed assets, such as furniture, fixtures, equipment, and real estate, as well as securities held as long-term investments. Occasionally you may also find intangible assets listed on the balance sheet.

Long-term liabilities are the total company debt that is due more than one year form the date of the balance sheet. You may be surprised to find stockholders’ equity listed as a liability. But it is listed that way because it reflects what the owner has invested in the company. In most privately held companies, the stockholders’ equity is the retained earnings that were left in the company to help it grow or, in some cases, to survive. It really can be viewed as a debt the company owes to the stockholders/

So a balance sheet can tell you a great deal about your target company. It can tell you if the company has enough cash to run the business, what the assets are, and how the assets compare to the liabilities.

Don’t be surprised to find that many companies are so highly leveraged that they actually have a negative net worth. If the company has substantial assets to borrow against, that could help you a great deal when it comes time to structure a debt package that will enable you to buy the company. If all the assets are already leverage, there’s nothing to borrow against, and it’s often tough to find a way to buy unless you have substantial cash. The balance sheet quickly tells you how much unused debt capacity is available.

And the balance sheet tells you even more. Once you have a basic understanding of what information is found here and why, you’ll be able to understand what your accountant is telling you about the health of your target company. Study the sample balance sheets until you understand what each entry means on both the asset and the liability sides.

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