Your Balance Sheet: Why It's Important
Posted Apr 28, 2011, Published 1998-09-01
The balance sheet—comprised of assets, liabilities and the owner's equity—provides a snapshot of the financial condition of your laboratory at any given time. It helps you quickly get a handle on the financial strength and capabilities of your business. Are you in a position to expand? Can you comfortably handle the normal financial ebbs and flows of revenues and expenses? Should you be taking immediate action to build up cash reserves? Balance sheet analysis can help you identify and analyze trends, particularly in the area of receivables and payables.
It compares your assets to your liabilities and equity. Assets are divided into current and long-term assets. Current assets can easily be converted into cash within one calendar year such as money market accounts or accounts receivable. Long-term assets include land, buildings, machinery and vehicles used for the business. Liabilities are your debts owed to outside creditors, vendors, banks and any retained earnings that are reinvested in the business. Click here for an example of a balance sheet.
Although there are numerous ratios you can determine from the balance sheet, there are three important ones you need to understand when talking to your banker.
The current ratio is an indication of the laboratory's ability to pay its current debts. To calculate it, you divide current assets by current liabilities. A ratio of 2:1 is preferable; a ratio of 1:1 is acceptable only if you have excellent cash flow. As the current ratio gets higher, creditors feel better about your ability to repay short-term credit.
The quick ratio measures your ability to pay debtors on an even shorter notice. You take current assets, subtract inventory, and divide by current liabilities. This number shows how solvent your laboratory would be if operations ceased abruptly. A ratio of 1:1 is considered very good; a ratio below this is not necessarily bad.
The debt-to-equity ratio tells what fraction of your assets are financed by debt. Divide total debt by equity. The lower the debt ratio the higher amount of equity used to finance assets, and the larger the buffer the creditors have to depend on. As the debt ratio increases, creditors' margin of safety decreases and so does their willingness to extend credit. Click here for more information on ratios.
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