Can your membership business continue to fund its growth? The balance sheet can answer this for you right away.
By knowing how to read a balance sheet, you’ll also be able to have a relevant discussion about it – or a discussion about the balance sheet of a business you’re interested in acquiring.
In addition, the balance sheet has two other uses: 1) Vendors and lenders can use the balance sheet in considering the creditworthiness of the business. 2) Owners and potential investors can use it to help determine the value of the business.
Let’s look at the balance sheet to get a picture of your financial health.
Getting to Know the Balance Sheet
First off, the balance sheet is a snapshot that helps you identify and analyze trends in the health of your business. The balance sheet reports on the financial condition of a business at a specific point in time.
Balance sheets are often shown with information from two or more dates, such as year-end information for the last two years.
Other key financial statements, such as profit and loss statements and cash flow statements, report financial activity over a given period of time.
Breaking It Down: How to Read a Balance Sheet
The balance sheet is made up of three parts:
- Assets — what you own
- Liabilities — what you owe
- Owner’s equity — the owner’s stake in the company
Take a look at the example balance sheet below. The company and amounts are fictional.
All About Assets
Let’s look at the left column first titled Assets.
What are assets? Assets are the things that the business owns that have monetary value, such as equipment. The assets are listed in order of liquidity, which is how quickly the items can be turned into cash.
Here’s an explanation of each line item:
Current Assets — assets that can be turned into cash within one year of the balance sheet date. The most liquid asset of every business is of course cash.
Accounts Receivable — amounts owed to the business by customers who made recent purchases on credit terms.
Inventory — items purchased by the business for resale to customers.
Prepaid Items — items that have been purchased but will be used and expensed on the profit and loss statement in a future period. A good example of a prepaid item is paying an insurance premium six months in advance.
Fixed Assets — sometimes called Property, Plant, and Equipment (PP&E), fixed assets are not considered very liquid and are therefore excluded from the current assets. Except for land, fixed assets depreciate over a period of years. They are listed at their purchased amounts, less accumulated depreciation to arrive at their net amount. Land is thought of as never losing value and is therefore not depreciated over a period of time.
A Look at Liabilities
What are liabilities? Liabilities are what the business owes to the various creditors and vendors. Like assets, liabilities are shown in current and non-current sections.
Again, an explanation of each line item from the top:
Current Liabilities — those amounts that must be paid within one year of the balance sheet date.
Accounts Payable — monies owed to vendors and suppliers for items acquired on credit.
Wages Payable — owed to employees and taxes payable amounts due to governmental taxing authorities.
Unearned Revenue — an item that is often not well understood by non-financial individuals. Unearned revenue is money received by the business for services not yet rendered or product not yet delivered to the customer. A good example in the member-service industry is membership fees paid-in-full by a member for the next year. The money has been received but the service for which the member is paying has not yet been rendered. Examples would be a one-year Martial Arts membership or a six-month Personal Training package. The service is still owed to the customer and therefore the revenue is unearned and reported in the liability section.
What Financial Analysts Look for When Reviewing Your Balance Sheet
One of the most common ratios that analysts use when viewing a balance sheet is called Working Capital, which is defined as current assets less current liabilities. The current ratio tells the reader whether or not the company has the liquid assets required to pay its obligations owed during the next year. If current liabilities exceed current assets, the company has no working capital.
Current Ratio is another common ratio used which is current assets divided by current liabilities. Higher ratios indicate more liquid companies. It is possible to be too liquid as investors would view the company as sitting on idle cash that could be invested elsewhere.
Non-Current Liabilities — amounts owed to creditors beyond one year ahead. Non-current liabilities are also referred to as long-term liabilities. The most common long-term liability is bank loans which are paid over several years.
Owner’s Equity — this equals assets less liabilities. The equity is comprised of the investment made by the owners into the company and the earnings retained by the company (versus distributed to the owners as dividends).
When All Is Said and Done
So now you have a basic understanding of what a balance sheet is and what the terms mean.
Remember that the balance sheet only shows a snapshot of the company at one particular date in time. It’s a useful tool to ensure your business finances are properly managed — and it can help uncover the true worth of your membership business.
To get the complete story on the health of your business, you must review the balance sheet, along with the profit and loss statement and cash flow statement.