This is the third and final installment in my series on how to review your year-end financial statements like a seasoned pro. So far we’ve looked at your Statement of Cash Flow and your Income Statement. Now it’s time to examine your other key financial statement, your Balance Sheet.
Your Balance Sheet provides a snapshot of your business’ financial condition at a specific moment in time – in this case, your fiscal year-end. It shows your firm’s assets, liabilities and owners’ or stockholders’ equity.
Compare to Last Year
Just like when evaluating your Income Statement, your starting point in understanding the picture that your Balance Sheet is painting about your business is to compare it to the prior year. Take a close look at:
• Cash – Did cash go up or down? Do the numbers match what’s on your Statement of Cash Flows? If not, an accounting error has been made somewhere…most likely in the Statement of Cash Flows, which can be tricky to compile.
• Working Capital – Working capital is your current assets minus your current liabilities. Is it positive or negative? Did it increase or decrease as compared to last year?
Look at Important Ratios
Next there are two important ratios that you should review:
• Current Ratio – The Current Ratio is the ratio of current assets to current liabilities. This provides an indication of your company’s liquidity and ability to pay back its liabilities.
Ideally, the Current Ratio will be stronger than 2:1. A ratio of 1:1 indicates that your company barely has the ability to meet its anticipated debts for the next 12 months. A ratio of less than 1:1 is usually a sign that your company is not in good financial health.
• Leverage Ratio – The “Leverage Ratio” is the ratio of debt to equity. Banks look at this ratio when deciding whether or not to approve a loan.
A ratio of 4:1 or above is considered highly leveraged.
A ratio of 2:1 or less is ideal. This indicates that your company has the ability to safely borrow additional debt.
A ratio of 2.5:1 or 3:1 is in the upper limits of most banks’ “safe zone.” Borrowing money at this point is possible but more difficult.
If you’ve been following this series you now know the secrets to evaluating your year-end financial statements. Of course, if you need any help with any of this, give me a call. As your part-time CFO, I’m here for you.