Like most of us, one day a business can be feeling quite healthy and chipper but the next day come down with a bug of some sort that can take it completely out of circulation. The financial health of a business, just like our own health, is equally at risk if someone doesn’t ‘take its pulse’ now and then to make sure it’s alive and kicking.

Just as a doctor will be alerted to potential problems by taking some initial measurements – temperature, pulse, blood pressure – the financial health of any business can be gauged by having some simple tests satisfied.

Prognosis starts with the balance sheet. This will give a good picture of the health of a business and provide an indication of its liquidity. The balance sheet will also identify any financial strengths, and perhaps weaknesses, for a potential investor. It is also the financial statement used to report on the business’s position for other stakeholders such as the bank or other providers of capital.

A balance sheet is a snapshot of a business’s financial position at a particular point in time. It summarises this position by showing both the business’s resources and financial obligations – or in other words, what the business owns (assets) and what it owes (liabilities).

From weighing one against the other, the end result will indicate the value of the ‘owner’s equity’ (or the net worth of the business). In fact the balance sheet is so named because the owner’s equity should be the balance of assets minus liabilities.

Why businesses prepare a balance sheet

A balance sheet will allow any business to:

• easily see the business’s financial strengths and weaknesses
• review its level of debt, working capital and assets
• compare growth and/or decrease in the business’s value over time
• reveal its relative liquidity
• review its ability to pay debts, and enable it to set appropriate debtor days
• review proportions of debt and equity financing, and capacity to retain earnings.

Assets can be seen as the resources that a business uses to operate – cash, land and buildings, machinery and equipment, and inventory. Generally, an asset is any item of value that is owned and controlled by the business that is used to generate revenue.

Assets are divided, for balance sheet purposes, into ‘current’ and ‘non-current’ assets. The former are items of value that are expected to last or be in use for less than 12 months. This would include cash and stock or inventory that is turning over regularly, and accounts receivable.

Non-current assets are those that are not expected to be so converted within a year, and would include premises, land, vehicles, plant and equipment.

Liabilities are the business’s obligations or debts, such as accounts payable, bank overdrafts, the provisions made for any staff leave owing, tax liabilities and amounts owing on loans. Basically, liabilities are the amounts owed by a business to other parties. Again, they are divided into ‘current’ and ‘non-current’.

Those that are current are expected to be settled within the next 12 months, and will include creditors (accounts payable), buying more stock or inventory, overdrafts, short-term loans and credit card debts. The non-current liabilities are those that will not be met within a year, such as mortgages on buildings and equipment, and long-term loan repayments.

Owner’s equity is therefore the resulting stake in the business’s assets after its liabilities are deducted – the amount belonging to the owner once all financial obligations have been met. It is the net worth of the business. Owner’s equity has also been called proprietorship, members’ funds and shareholder equity.

So if a business’s total assets are greater than total liabilities, which is hopefully the case, its net worth or owner’s equity will be in positive territory.

Equity is also divided up, and includes the initial and ongoing investment made by the owner or owners – the capital, which is any cash or assets contributed to the business. Then there are retained earnings, which are any profits made that are reinvested back into the business (or these could be accumulated losses). And then there are reserves, which are profits that are set aside for replacing used-up assets, or building and infrastructure maintenance.

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While the profitability of a business can serve as a window into its fiscal health, it should not be mistaken for an absolutely definitive declaration of financial viability. A profit statement can be viewed as a magnifying glass, not a microscope. This can be especially pertinent when considering investing in a business.

There are other various factors at work with the viability of every business, some dependent on the industry involved but others common across most enterprises. The perennial warning of caveat emptor is the fall-back advice with every investment, even with the reassurance of good incomings.

An example to keep in mind is Albert ‘Chainsaw’ Dunlap when he was CEO of Sunbeam Appliances in the US. The troubled company enlisted Chainsaw to turn around its fortunes, which he had become famous for with other businesses.

Ever a ‘numbers’ man, Dunlap slashed, burned and cajoled the profitability of Sunbeam up beyond the market’s previously dim expectations, and its share price responded accordingly. But within a very short time the party stopped, profit plunged, and the company went decidedly sour.

What had happened? No-one knew until some bright spark decided to take a good look at the balance sheet.

The balance sheet showed that the money owed to the company by customers had ballooned enormously at the same time its product sales were apparently meant to have gone through the roof.

Drilling down into the numbers contained in the balance sheet, it was found that Sunbeam had done a deal with its suppliers so that the company could ‘sell’ stock at a discount that distributors would not want for many months (items like electric blankets in summer), which were then ‘held’ until needed. The distributors would only be liable to actually hand over money upon receipt of the items (so it was an enticing deal for them).

In other words, the ‘profit’ was a fairy tale. By the time summer inevitably rolled around, the distributors were already stocked up to the hilt, and the jig was up. The sales and profit were revealed (on account of the balance sheet) as fictitious accounting tricks.

Even the Australian Securities and Investments Commission has used the Chainsaw Dunlap example in discussing financial statement fraud (see page four of this transcript), so you can see just how important knowing your way around a balance sheet can be.

Example balance sheet

ASSETS		LIABILITIES
Current assets		Current liabilities
Cash	$2,100	Notes payable	$5,000
Petty cash	100	Accounts payable	35,900
Temporary investments	10,000	Wages payable	8,500
Accounts receivable – net	40,500	Interest payable	2,900
Inventory	31,000	Taxes payable	6,100
Supplies	3,800	Warranty liability	1,100
Prepaid insurance	1,500	Unearned revenues	1,500
Total current assets	89,000	Total current liabilities	61,000
Investments	36,000	Long-term liabilities
Property, plant and equipment		Notes payable	20,000
Land	5,500	Bonds payable	400,000
Land improvements	6,500	Total long-term liabilities	420,000
Buildings	180,000	Total liabilities	481,000
Equipment	201,000
Less: Accum depreciation	(56,000)
Prop, plant and equipment – net	337,000
Intangible assets		Stockholders’ equity
Goodwill	105,000	Common stock	110,000
Trade names	200,000	Retained earnings	229,000
Total intangible assets	305,000	Less: Treasury stock	(50,000)
Other assets	3,000	Total stockholders’ equity	289,000
Total assets	$770,000	Total liabilities and stockholders’ equity	$770,000

 

This story first appeared at taxpayersassociation.com.au