If you look at a balance sheet, you first need to look for the balance: Assets = Liabilities
As told before, assets always need to match liabilities.
Every balance sheet, all over the world, is divided in five blocks:
Gross assets are no problem as such, but assets which consume a lot of money need some follow up. For example:
The most important entry to check a company’s health is the internal equity. You best check three things:
Why is this so important?
Is the company mainly being financed by capital, or by debts? Solvency is often defined as follows: Solvency = Equity/Total liabilities
What is a good solvency level? In the financial world a solvency between 25% and 30% is seen as good.
Before we close this topic and conclude with an example, let’s dwell a moment on the characteristics of equity and debts.
The shareholder, as the provider of equity, is taking the highest risk as he can only be compensated with dividends, and dividend can only be paid when a company has profits. As long as there is no profit, the shareholder cannot get any return. As they run the highest risk, our market economy argues that their return on investment (dividends) should be higher than the compensation for other liabilities. This means equity is considered the most expensive source of money. Some legal forms for social enterprises limit the dividend rate at 4% – 6%.
A company can also be financed by debt. A bank doesn’t care weather this company makes a profit or loss, as they will always receive interests. There are no extra expectations, the bank cannot expect you to pay more interest if you make more profit.
Liquidity answers the question: will this company run into trouble in the short term? Can the company pay its short-term debts? It can only do so if it has enough current assets and cash.
You determine the liquidity ratio as follows:
Liquidity = Current assets / Current liabilities
By dividing the current assets by the short-term debts (debts payable within 1 year) you obtain a percentage. This percentage is called the liquidity ratio. Most authors apply the rule that good liquidity starts with a ratio of 1 or higher. In other words: if the result of the higher formula is 1 or higher, you have a good ratio.
The reason behind the formula is that a healthy company has more current assets than current liabilities. After all, the current assets must enable the company to pay its debts that fall due in the short term. If there are too few current assets to meet short-term obligations, the company must find those resources elsewhere.