In the balance: how to read your balance sheet - Strickly Business

Custom Home, Jan-Feb, 2004 by Steve Maltzman

Many custom builders get a balance sheet for review at the end of each month from their accounting system. I find, however, that very few of them use this report as a tool to analyze their companies' financial results.

A balance sheet is simply a snapshot of a business's financial condition at a specific moment in time, usually at the close of an accounting period. A balance sheet comprises assets, liabilities, and owners' or stockholders' equity. Assets and liabilities are divided into short- and long-term obligations including cash accounts such as checking, money market, or government securities. At any given time, assets must equal liabilities plus owners' equity.

This statement is also referred to as a statement of financial position or a statement of financial condition. The balance sheet presents net balances at the end of an accounting period, rather than the total transactions for the period presented in the income statement. The balance sheet allows the custom builder to know how much cash he has in the bank, how much money he is owed, what equipment is on hand, and so on, at a given period of time.

The concept behind the balance sheet is very simple. In order to acquire assets, a firm must pay for them with either debt (liabilities) or with the owners' capital (shareholders' equity). Therefore, the following equation must hold true:

                       Shareholders'
Assets = Liabilities    Equity

Total Liabilities      $30,000
Shareholders' Equity   $50,000

Total Assets           $80,000

Assets are what the firm has, and liabilities are what the firm owes. The difference between the two is equity or the firm's worth. For example, if the firm's assets are $1 million and its liabilities are $600,000, its equity is $400,000. Assets minus liabilities equal equity. Or, looked at another way, assets equal liabilities plus equity. The balance sheet is typically written in this latter form, with assets listed on the left and liabilities plus equity listed on the right. The columns are totaled at the bottom. As the name implies, the balance sheet's bottom lines must always balance. In other words, the total assets are equal to total liabilities plus net worth.

Particular items in a balance sheet may vary significantly from day to day. Over time, though, these "snapshots" of a company taken on a yearly or monthly basis, can reveal important information about the ability of the company to satisfy its creditors, manage inventory, and collect its receivables.

Proper analysis of a balance sheet will help you understand and evaluate your financial strength, liquidity, and leverage. It will also provide information that will help you formulate and monitor company goals and plans. A balance sheet helps you quickly get a handle on the financial strength and capabilities of your business: Is the business in a position to expand? Can the business easily handle the normal financial ebb and flow of revenue and expenses? Should the business take immediate steps to bolster cash reserves?

Analyzing the balance sheet also provides information on changes in the financial structure of your company. Observing changes and identifying trends helps to identify what good and bad things are happening to it. Trends are more useful than numbers. They provide the knowledge, first, to see if there is a trend; second, to determine whether the trend is good or bad; and third, to take appropriate action.

Doctors use their education, experience, and---occasionally--some inspiration to diagnose the physical health of a patient. A doctor typically runs through a series of tests and compares the test results with the patient's condition before the tests, rather than merely concentrating on the test results. The doctor is looking for good and bad trends. The subsequent analysis will identify what the patient might do to bolster the good trends and reduce the bad ones. Balance sheet analysis similarly looks at the financial health of a firm. The analysis runs the business through a series of tests and needs more than one number to show the complete picture.

Many accounting systems compare the current month balances to the same period in the prior year. While this may be good for companies in other industries, I believe that it really doesn't provide much of a basis for analysis to builders. The best way for a custom builder to look at his balance sheet is to compare the balances of the current month with the prior month's balances. This information should be shown on your balance sheet plus a column that reflects the change between the periods. Comparing balances between the end of the current month and the prior month lets you see the changes that have occurred in assets, liabilities, and equity during the month.

In order to truly gain a handle on the balance sheet, it is important for custom builders to report financial results on a percentage-of-completion basis, reflecting underbillings and overbillings on the balance sheet. (For a discussion of percentage-of-completion accounting see November/December 2002, page 18, "Back to Basics.")