As a successful business owner, you understand that financial stability is key in order to maintain the longevity of your company; it’s essential for continued growth. One primary factor of achieving this goal is having an accurate understanding of one’s balance sheet and how each asset contributes to the overall picture. Furthermore, applying this to your clients and suppliers, can also provide valuable insights into the stability of your business overall!Importance of a balance sheet

Having resources available to decipher what affects or influences bottom-line numbers can assist you in making strategic decisions based on reliable data – so let’s dive into why understanding a balance sheet is important here!

Not all financial information is available all of the time

When assessing the viability of other companies, whether suppliers or clients, their annual accounts posted on Companies House may not provide a full set of financial reports, only the balance sheet may be available. As this is the most usual financial report available, we’ll look at the balance sheet in more detail below, but having access to income statements and cash flow statements would provide a more balanced view of a company’s financial standing. These may be possible to acquire if your company is entering into a more formal business relationship with the other party and as such would form part of your own due diligence process.

However, on its own, the balance sheet can still provide some useful first insights into a company’s standing, as well as your own.

Here are some of the questions we pose in this article:

  1. What is the balance sheet and why is it important to understand?
  2. What are the essential elements of a balance sheet that help somebody understand the health of a company?
  3. What are key ratios and how are these derived from a balance sheet?
  4. I’m looking at doing business with a new supplier, what specific aspects of their balance sheet should I be looking at?
  5. How can you use a balance sheet to assess whether a new client is worth doing business with?

What is the balance sheet and why it is important to understand?

A balance sheet is a financial statement that provides a snapshot of a company’s financial position at a given point in time. It summarises the company’s assets, liabilities, and equity, and is an important tool for assessing the financial health and stability of a company.

A balance sheet is particularly important for several reasons:

  1. Compliance: Companies are required by law to prepare and file annual financial statements, including a balance sheet, with Companies House. These statements must comply with the UK accounting standards, and failure to comply can result in penalties.
  2. Financial analysis: A balance sheet is a key tool for financial analysis, allowing investors, creditors, and other stakeholders to evaluate a company’s financial position and make informed decisions about whether to invest in or lend to the company.
  3. Decision-making: A balance sheet provides important information for decision-making within a company. For example, it can help management assess the company’s liquidity and working capital, which can inform decisions about capital expenditures, dividend payments, and other strategic initiatives.
  4. Transparency: A balance sheet provides transparency and accountability, allowing stakeholders to see how a company’s assets are deployed and how its liabilities are managed. This can be particularly important for companies with complex financial arrangements or significant debt.Understanding the elements of a balance sheet is an important part of smart financial management for any business owner. While it takes some training to intuitively understand how to interpret the information on balance sheets, keeping up with its evolution can be immensely beneficial for running a successful business. With an increasingly digital world, technology advancements have put critical data only a few clicks away, so it’s easier than ever to stay ahead of compliance regulations and use this data to make informed decisions about your finances. Whether you’re just getting started or are a seasoned veteran in the business ownership game, having awareness of the basics of a balance sheet can go a long way towards setting your company up for success.

What are the essential elements of a balance sheet that help somebody understand the health of a company?

There are three essential elements of a balance sheet that can help somebody understand the health of a company:

  1. Assets: Assets are what a company owns or controls, such as cash, inventory, property, plant and equipment, and investments. A strong balance sheet typically has a healthy mix of short-term and long-term assets, indicating that the company has enough resources to meet its obligations in the near term and invest in its future growth.
  2. Liabilities: Liabilities are what a company owes to others, such as loans, accounts payable, and deferred revenue. A strong balance sheet typically has a manageable level of liabilities relative to its assets, indicating that the company is able to meet its financial obligations.
  3. Equity: Equity represents the residual value of a company’s assets after its liabilities are subtracted. It includes items such as common stock, retained earnings, and other comprehensive income. A strong balance sheet typically has a healthy level of equity, indicating that the company has a strong financial foundation and is able to withstand economic shocks.

In addition to these essential elements, other factors that can help somebody understand the health of a company include the quality of the assets (such as whether they are depreciating quickly), the maturity and interest rate of the liabilities (such as whether they are due in the near term or the long term), and any off-balance sheet items that could impact the company’s financial health.

Key ratios and what they mean

The current ratio is a financial ratio that compares a company’s current assets to its current liabilities. It is calculated by dividing the total current assets of a business by its total current liabilities. The resulting ratio provides an indication of a company’s short-term liquidity and ability to pay its bills and other obligations in the near future.

A higher current ratio is generally viewed as more favorable, as it indicates that the company has more current assets to cover its current liabilities, suggesting that it is in a better position to pay its debts and meet its obligations. However, a very high current ratio may suggest that the company is not effectively using its current assets to generate revenue, which could potentially result in missed growth opportunities.

On the other hand, a low current ratio may indicate that the company is struggling to meet its short-term obligations, which could result in missed payments to suppliers, employees, or creditors. This may also suggest that the company has a high level of debt or is experiencing cash flow problems.

It’s important to note that the current ratio is just one of many factors to consider when evaluating a company’s financial health, and it should not be considered in isolation. Other financial ratios, such as the quick ratio, debt-to-equity ratio, and return on investment, can provide additional insights into a company’s financial performance and should also be considered in conjunction with the current ratio.

Overall, the current ratio is a useful tool for assessing a company’s short-term liquidity and ability to meet its near-term obligations. However, it should be used in combination with other financial ratios and metrics to gain a comprehensive understanding of a company’s overall financial health.

The debt-to-equity ratio is a financial ratio that compares a company’s total debt to its total equity. It is calculated by dividing the total liabilities of a business by its total shareholders’ equity. The resulting ratio provides an indication of a company’s financial leverage and the degree to which it is financed by debt as opposed to equity.

A high debt-to-equity ratio suggests that a company has a higher level of debt relative to equity, which may indicate that it is taking on more financial risk. This may be a cause for concern for investors, as a high debt-to-equity ratio may make the company more vulnerable to changes in interest rates or economic conditions. It may also suggest that the company has limited flexibility to invest in growth opportunities or to weather unexpected financial challenges.

On the other hand, a low debt-to-equity ratio suggests that the company has a lower level of debt relative to equity, which may indicate that it is taking on less financial risk. This may be viewed more positively by investors, as it suggests that the company has more financial flexibility and may be better positioned to withstand changes in economic conditions or other financial challenges.

It’s important to note that the ideal debt-to-equity ratio can vary widely depending on the industry in which a company operates, as well as its stage of development and growth trajectory. Companies in certain industries, such as utilities or telecommunications, may have higher debt-to-equity ratios due to the nature of their operations, while start-up companies may have a higher debt-to-equity ratio as they seek to raise capital for growth.

Overall, the debt-to-equity ratio is a useful tool for assessing a company’s financial leverage and the degree to which it is financed by debt. However, it should be used in combination with other financial ratios and metrics to gain a comprehensive understanding of a company’s overall financial health.

Return on equity (ROE) is a financial ratio that measures a company’s profitability by calculating the amount of net income earned as a percentage of shareholders’ equity. ROE is calculated by dividing a company’s net income by its average shareholder equity over a given period of time.

ROE is an important measure of a company’s financial performance, as it indicates how effectively a company is generating profits from the capital invested by shareholders. A higher ROE suggests that a company is effectively utilising the investments made by its shareholders to generate profits, while a lower ROE may indicate that a company is struggling to generate returns on shareholder investments.

A high ROE is generally viewed as more favourable, as it indicates that a company is generating significant profits relative to the amount of shareholder equity invested in the business. This may also suggest that the company has a competitive advantage in its industry, which allows it to generate higher profits than its peers.

On the other hand, a low ROE may indicate that a company is not effectively utilising its resources to generate profits or is facing challenges in its industry. This may be a cause for concern for investors, as it suggests that the company may be less attractive in terms of potential returns on investment.

It’s important to note that ROE can vary widely depending on the industry in which a company operates, as well as its stage of development and growth trajectory. Companies in certain industries, such as technology or biotech, may have lower ROEs due to the nature of their business models, while mature companies may have more stable and predictable ROEs.

Overall, ROE is a useful tool for assessing a company’s profitability and the degree to which it is generating returns for its shareholders. However, it should be used in combination with other financial ratios and metrics to gain a comprehensive understanding of a company’s overall financial health.

The asset turnover ratio is a financial ratio that measures a company’s efficiency in generating revenue from its assets. It is calculated by dividing a company’s net sales by its total assets. The resulting ratio provides an indication of how effectively a company is using its assets to generate revenue.

A higher asset turnover ratio is generally viewed as more favourable, as it indicates that a company is generating more revenue from its assets. This may suggest that the company has efficient operations or is effectively managing its assets to maximise revenue generation.

On the other hand, a lower asset turnover ratio may indicate that a company is not effectively utilising its assets to generate revenue, which could be a cause for concern for investors. This may suggest that the company is not effectively managing its operations or that it is facing challenges in its industry.

It’s important to note that the ideal asset turnover ratio can vary widely depending on the industry in which a company operates, as well as its stage of development and growth trajectory. For example, asset-intensive industries such as manufacturing or utilities may have lower asset turnover ratios due to the nature of their operations, while service-based industries may have higher asset turnover ratios.

Overall, the asset turnover ratio is a useful tool for assessing a company’s efficiency in generating revenue from its assets. However, it should be used in combination with other financial ratios and metrics to gain a comprehensive understanding of a company’s overall financial health.

Gross profit margin is a financial ratio that measures a company’s profitability by calculating the percentage of revenue that exceeds the cost of goods sold (COGS). The gross profit margin is calculated by subtracting the COGS from a company’s total revenue and then dividing the result by the total revenue.

A higher gross profit margin is generally viewed as more favourable, as it indicates that a company is generating a higher percentage of profit from each sale. This may suggest that the company is effectively managing its costs, including the costs of production and the cost of goods sold, and is pricing its products or services appropriately to maximise revenue.

On the other hand, a lower gross profit margin may indicate that a company is facing challenges in managing its costs or is pricing its products or services too low to generate sufficient revenue.

It’s important to note that the ideal gross profit margin can vary widely depending on the industry in which a company operates, as well as its stage of development and growth trajectory. For example, companies operating in highly competitive industries may have lower gross profit margins due to pricing pressures, while companies with more unique products or services may have higher gross profit margins.

Overall, the gross profit margin is a useful tool for assessing a company’s profitability and the degree to which it is generating profit from each sale. However, it should be used in combination with other financial ratios and metrics to gain a comprehensive understanding of a company’s overall financial health.

Exploring the financial ratios from a company’s balance sheet, income statement, and cash flow statements can provide stakeholders with valuable insight into its health. With this information in hand, they have the data to make smart decisions about investing or partnering opportunities.

how to use a balance sheet

I’m looking at doing business with a new supplier, what specific aspects of their balance sheet should I be looking at?

As experienced accountants, we would recommend that you consider several specific aspects of a potential supplier’s balance sheet when evaluating their financial health. Also, if you can get hold of them, there are a few other factors you out to consider, we’ve included these too. Together these factors can provide valuable insights into the supplier’s liquidity, debt levels, inventory management, profitability, and ability to meet their financial obligations.

Liquidity:
When evaluating a supplier’s balance sheet, it is essential to consider their liquidity. This can be assessed by reviewing their current assets and liabilities. Current assets include cash, accounts receivable, and inventory, while current liabilities include accounts payable, short-term loans, and other short-term obligations. A supplier’s liquidity is crucial because it indicates their ability to pay their bills on time and keep their business running. If a supplier has a low current ratio, it could indicate that they may struggle to pay their bills on time or may be at risk of insolvency.

Debt levels:
The supplier’s debt levels are also an essential aspect to consider. Total debt includes short-term and long-term debt, such as bank loans, bonds, or other financing agreements. The debt-to-equity ratio is a crucial indicator that measures the amount of debt a company has compared to its equity. A high level of debt can be a warning sign of financial risk or potential difficulties in meeting their financial obligations. It is also essential to review their interest expense and maturity schedule of their debt to gain a better understanding of their ability to service their debt.

Accounts receivable:
The supplier’s accounts receivable balance and aging schedule are important to assess their ability to collect payments from customers. A high level of overdue accounts receivable may indicate potential cash flow problems or issues with their customer base. You want to ensure that the supplier has a low level of overdue accounts receivable and that they have efficient processes for collecting payments from their customers. Additionally, reviewing their credit policy and customer concentration can provide insights into potential risks in their accounts receivable.

Inventory turnover:
Assessing the supplier’s inventory turnover ratio is also important for understanding their inventory management practices. A low inventory turnover ratio may indicate potential obsolescence or inefficiencies in their operations, while a high inventory turnover ratio may indicate strong sales or efficient inventory management.

Gross margin:
The supplier’s gross margin can provide valuable insights into their pricing strategy and cost structure. A low gross margin may indicate pricing pressures or high costs that could impact their profitability, while a high gross margin may indicate strong pricing power or efficient cost management.

Working capital:
Reviewing the supplier’s working capital is important for assessing their ability to meet their short-term obligations. You should ensure that the supplier has sufficient working capital to cover their current liabilities, such as paying suppliers or employees. Additionally, reviewing their trade payable and receivable terms can provide insights into their cash conversion cycle and working capital management practices.

Capital expenditures:
Finally, reviewing the supplier’s capital expenditures is important for assessing their investments in property, plant, and equipment. You want to ensure that the supplier is investing in their operations and has the capacity to fulfill your business needs. Additionally, reviewing their depreciation schedule and asset quality can provide insights into their long-term capital investment strategy.

By considering these specific aspects of a potential supplier’s balance sheet, you can gain a deeper understanding of their financial health and make more informed decisions about whether or not to do business with them. As expert accountants, we are always here to provide guidance and support to help you make the best financial decisions for your business.

How you can use a balance sheet (and other reports if you can get them) to assess whether a new client or partner is worth doing business with?

Analysing financial health doesn’t have to be a daunting prospect. Evaluating key metrics like liquidity, debt levels, accounts receivable and inventory turnover can all provide insight into their ability to generate cash flow for the future. By taking time to understand these numbers as well as analysing potential clients’ capital expenditures are essential steps in determining whether they’re suitable for your business goals.

Review the current assets and liabilities:
By looking at a potential client’s current assets and liabilities, you can assess their liquidity and short-term financial health. Current assets include cash, accounts receivable, and inventory, while current liabilities include accounts payable, short-term loans, and other short-term obligations. You want to ensure that the client has enough current assets to cover their current liabilities. A high current ratio is generally seen as favourable, as it indicates that the client has sufficient liquidity to meet their short-term obligations.

Assess the long-term financial health:
To evaluate a potential client’s long-term financial health, you should review their total assets, liabilities, and equity. This will help you understand the client’s overall financial position and their ability to meet their long-term obligations. You should also review their debt-to-equity ratio to see how much debt the client is carrying compared to their equity. A high debt-to-equity ratio may indicate a high level of risk, as the client may have difficulty servicing their debt obligations in the long-term.

Analyse the accounts receivable:
The client’s accounts receivable can provide valuable insights into their credit and collection policies. You want to ensure that the client has an efficient process for collecting payments from their customers and that they have a low level of overdue accounts receivable. A high level of overdue accounts receivable may indicate potential cash flow problems or issues with their customer base.

Assess the profitability:
By reviewing the client’s income statement, you can assess their profitability and revenue trends over time. You should review their gross margin and net profit margin to understand how well the client is managing their costs and pricing their products or services. You can also review their revenue growth rate to see how their business is expanding over time.

Analyse the cash flow statement:
Analysing a potential client’s cash flow statement can help you understand how they generate and use cash, including cash flows from operating activities, investing activities, and financing activities. By reviewing their cash flow statement, you can assess their ability to generate cash and manage their cash flows effectively. A positive cash flow from operations is generally seen as favourable, as it indicates that the client has sufficient cash to fund their operations.

Review the working capital:
Reviewing the client’s working capital is important for assessing their ability to meet their short-term obligations. You should ensure that the client has sufficient working capital to cover their current liabilities, such as paying suppliers or employees. Additionally, reviewing their trade payable and receivable terms can provide insights into their cash conversion cycle and working capital management practices.

Assess the capital expenditures:
Finally, reviewing the client’s capital expenditures is important for assessing their investments in property, plant, and equipment. You want to ensure that the client is investing in their operations and has the capacity to fulfil their business needs. Additionally, reviewing their depreciation schedule and asset quality can provide insights into their long-term capital investment strategy.

By considering these specific aspects of a potential client’s balance sheet and other financial reports, you can gain a deeper understanding of their financial health and make more informed decisions about whether or not to do business with them. Additionally, being able to analyse the firm’s cash flow statement can provide valuable insights into their ability to generate and manage cash effectively, allowing you to make more informed business decisions.

Talk to TaxAgility about improving your business efficiency

TaxAgility are experts in analysing the performance of your company and helping you find ways to improve your business’s efficiency. If you’d like understand more about how we can help you manage your business, call TaxAgility today on 020 8108 0090.