Balance Sheet Analysis: How They’re Used in Corporate Finance
Executives, managers, business owners, and investors all stand to benefit from understanding the fundamentals of balance sheet analysis. To grow a company, smart investments must be made and financial risks must be avoided. Financial statements and balance sheets are crucial for executives and business managers to get an accurate picture of what their enterprise is worth. These informative documents can help senior decision-makers reduce risks and recognize opportunities that can benefit the financial standing of a corporation.
The Purpose of a Balance Sheet
The balance sheet is a record of a company’s assets and liabilities. In other words, investors use them to break down how much money a company has and how much it owes. The difference between the assets and liabilities signifies the net worth or shareholder equity depending on what is being measured.
One of the main purposes of analyzing a balance sheet is to determine the working capital of an organization, showing the short-term liquidity position. It tells business managers the financial assets remaining if a company used all of its resources to pay off its liabilities. Working capital helps evaluate the financial strain on a company and whether or not it has the resources to expand on its own or if additional funds and investments are required. Understanding the financial position allows corporations to make critical decisions regarding where their enterprise is headed.
Reading a Balance Sheet
The balance sheet is divided into two parts: assets and liabilities. Understanding the figures within each of these sections can help business managers and executives analyze values and evaluate their company’s position.
The current assets of an organization generally have a lifespan of a year or less and can be quickly and easily converted into cash. These assets include cash, such as non-restricted bank accounts and checks, and cash equivalents, which account for safe assets that can easily be made liquid. Current assets are also made up of inventory, raw materials, accounts receivable and other money owed, including stocks and bonds and prepaid expenses.
These assets are not readily turned into cash simply because they feature a short lifespan of a year or more. Tangible assets are included in this category, such as machinery, electronics, computers, buildings, and land. Goodwill, patents, and brand name value are classified as intangible assets and can be very valuable resources for an organization.
Any liability that a business owes to creditors becoming due within one year or less of the balance sheet date is a current liability. These include a variety of expenses such as accounts payable, accrued expenses, wages and salaries, taxes and payroll taxes, notes payable to banks and any other loans due within twelve months.
Long-term liabilities are made of up debts and other financial obligations with a due date of at least one year from the balance sheet date. These figures often include startup financing which may come from initial sources such as relatives, banks, or other finance organizations.
The initial money invested in a business is known as shareholders’ equity. Companies can opt to reinvest their net earnings after taxes back into the company at the end of a fiscal year. These earnings will be represented on the balance sheet in the shareholders’ equity account, signifying the total net worth of a business.
The Value of Balance Sheet Analysis for Executive Team
Balance sheet analysis holds significant value for those in charge of the decision-making process regarding a company’s investments. A significant value for the executive team lies in the ability to foresee future financial difficulties. If a company discovers that they do not have enough liquid assets, they would be able to make the necessary adjustments before they feel pressure to increase reliance on loans or incur fees from late payments to vendors. Financial difficulties can lead to lower corporate credit ratings, which result in added costs for a company, such as high interest rates.
Executives can also find value when using the balance sheet in conjunction with income and cash flow statements to help determine a business’s debt compared to its equity.
The information available from these combined financial statements can help a company determine if they need to decrease or increase short-term cash, how fast their customers are paying their bills, the lifecycle of on-hand inventory, the percentage of tangible assets and the average interest rate a company pays on its debt.
The decisions made in corporate finance can have a significant impact on a business’s chances of staying afloat. Learning balance sheet analysis is essential for understanding a company’s financial status. Business managers and finance professionals have these tools at their disposable when making investment decisions for their organization.
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