A strong balance sheet goes beyond just necessary accounting; businesses with strong balance sheets are more likely to survive economic downturns and be ready to drive strong growth when the environment flourishes once more. In this article, we discuss what makes a strong balance sheet, and why it’s important.
So, what makes a strong balance sheet? A company with a strong balance sheet are those that are structured to support the business’ goals and maximise profits. A strong balance sheet should include; intelligent working capital, positive cash flow, a balanced capital structure, and income generating assets.
Read on to learn more about what makes a strong balance sheet, and the factors that impact it.
- How Do You Know if a Balance Sheet is Strong?
- What is the Most Important Thing on a Balance Sheet?
- What is a Good Balance Sheet Ratio?
- Why is a Strong Balance Sheet Important?
How Do You Know if a Balance Sheet is Strong?
If you’re not an accountant it can be difficult to know how well your company is performing financially. The following steps below will help you to determine whether or not your company is financially strong based on balance sheet financial data.
- When deciding if your company’s balance sheet is healthy, begin by determining if the company has enough current assets to pay its financial obligations. A company that has more liabilities than assets is considered financially weak.
- Calculate the current ratio by dividing the total of your company’s current assets by current liabilities. A current ratio of 1 or greater is preferable when deciding financial strength.
- Calculate the quick ratio by subtracting inventory from current assets and dividing that result by current liabilities. A quick ratio higher than 1 means that your company is in a good financial position.
- Calculate the cash-to-debt ratio by adding cash and short-term investments and dividing that total by current and long-term liabilities. A favorable cash-to-debt ratio is anything equal to or exceeding 1.5.
- Calculate the debt-to-equity ratio by dividing the total amount of your company’s liabilities by shareholders’ equity. If the ratio is lower than 1, it means that your company is purchasing most of its assets with equity, which shows financial strength.
- Determine whether important data on the balance sheet is improving or declining over time by examining past balance sheets and trends. Compare the financial data of your balance sheet to similar companies’ balance sheets and industry ratios.
What is a Weak Balance Sheet?
A weak balance sheet will typically reveal a poorly performing business. The balance sheet will often detail some of the following factors:
- Negative equity
- Negative or deficit retained earning
- Negative net tangible assets
- Low current ratio
What Factors Evaluate Financial Strength?
Businesses with strong balance sheets tend to go beyond just having more assets than liabilities; they are structured to maximise efficiency and performance and to support the goals of the entire business.
A strong balance sheet will usually tick the following boxes:
- They will have a positive net asset position
- They will have the right amount of key assets
- They will have more debtors than creditors
- They will have a fast-moving receivables ledger
- They will have a good debt-to-equity ratio
- They will have a strong current ratio
What is the Most Important Thing on a Balance Sheet?
There are three key factors to look out for on a balance sheet; assets, liabilities, and equity.
Assets should be divided up into current assets and noncurrent assets. Current assets include cash, inventories, and net receivables. However, cash is the most important asset.
Again, like assets, liabilities are split into current and noncurrent liabilities, where Current liabilities are obligations due within a year. Analysts look for fewer liabilities than assets, particularly in comparison to cash flow.
Common liabilities include:
- Accounts payable
- Deferred income
- Long-term debt
- Customer deposits
Equity is equal to assets minus liabilities, and it represents how much the company’s shareholders actually have a claim to. Pay particular attention to retained earnings.
What is a Good Balance Sheet Ratio?
You can get a better understanding of the financial situation of your business by performing a few quick calculations using information contained within your balance sheet.
This allows you to know if your company has enough cash and short-term assets on hand to pay short-term bills. Use the Current Assets and Current Liabilities data to work this out:
Current Ratio = Current Assets ÷ Current Liabilities
From this calculation, a ratio of 1.5 to 2 would be adequate, but this also depends on the industry in which your company operates.
A quick ratio is similar to the above but removes inventories from the equation. Use the below calculation:
Quick Ratio = (Current Assets – Inventories) ÷ Current Liabilities
A quick ratio higher than 1 is generally considered as safe, but this also depends on the industry in which your company operates.
Working capital is the difference between current assets and current liabilities, but whether the calculation is positive or negative will depend on the industry in which your company operates. Work this out using the following formula:
Working Capital = Current Assets – Current Liabilities
While a positive working capital metric is desirable in certain industries, a negative working capital metric is viewed favourably in others.
One of the most important ratios derived from a balance sheet is debt/equity, detailing how much your business depends on debt. Work this out using the following calculation:
Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders’ Equity
For most companies, a lower ratio is viewed more favourably, however, a ratio of 0 can look equally bad, indicating an inefficient capital structure.
Why is a Strong Balance Sheet Important?
A balance sheet provides you with a snapshot of what your business both owns and owes within a financial year. This, when compared to previous balance sheets, gives you an indication of how well your business has done in the last 12 months.
This then lets investors the information they need to make informed decisions about lending. A balance sheet can also help you to make informed decisions and provide warnings of a weak financial position.
Accounting and Bookkeeping Services Essex
ARB Accountants offer a wide range of accounting and bookkeeping services in Essex and across the UK, including the preparation of balance sheets. Our chartered accountants in Essex will calculate your annual balance sheet whilst ensuring that you fully understand your financial landscape, and how it can impact your business.
Get in touch with us today to learn more about how we can help you keep on top of your business’ finances.