Checking a Balance Sheet in 6 Steps

You want to learn how to check a balance sheet? We designed six steps to guide you through the exercise. The first 2 steps are about basic check-ups, the following four help you to analyze the health of the company.

Check 1: Look for the Balance

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.

source: shutterstock.com

Check 2: Find the Five Blocks

Every balance sheet, all over the world, is divided in five blocks:

  • Fixed assets
  • Currents assets
  • Equity
  • (Provisions)
  • Debts
source: pixabay.com
It’s good to know that an American balance sheet is upside down: they start the assets with the current assets and the liabilities with the debts.

Check 3: Assets - Where Are the Gross Assets?

Gross assets are no problem as such, but assets which consume a lot of money need some follow up. For example:

  • If half of the assets are in inventory, then inventory management will need to be tracked carefully. Is the inventory rotated enough? Do they have an expiration date? What about depreciations?
  • If a lot of money is invested in machines, the efficient use of the machines and their maintenance is important.
source: shutterstock.com

Check 4: Liabilities - Is there a Positive Internal Equity?

The most important entry to check a company’s health is the internal equity. You best check three things:

  • Is the internal equity a positive number?
  • Does the internal equity come to at least 10% of the total liabilities?
source: pixabay.com

Why is this so important?

  • Internal equity is a proof the company is making profit and able to retain some reserves to build a future.
  • It means the shareholders didn’t take all the profit out of the company to pay for dividends. Legally the profit belongs to the shareholders, but a responsible shareholder doesn’t take all the profit out of the company. He leaves enough in the company so the company has enough oxygen to breathe and blossom.

Check 5: Liabilities - The Solvency Ratio

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.

source: unsplash.com

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.


Summarized:

  • Compensation for equity: dividend
  • Compensation for debts: interest

Check 6: Assets – Liquidity Ratio

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.

source: pixabay.com

Examples

Let’s check the balance sheet of the first example according to the above 6 steps.

Check 1: Assets equal liabilities
Check 2: We can find gross assets invested in a building. Inventory is 15% of the total, which is not too much.
Check 3: Internal equity is positive and amounts to 25% of total equity
Check 4: Solvency amounts to 50% (50,000/100,000) which is high
Check 5: Liquidity amounts to 8 (Current assets/Payables), which is also high and good.