A Healthy Balance Sheet and Why It Matters

A healthy balance sheet shows a company has adequate solvency and liquidity, appropriate borrowing, adequate capital and a positive trend or forecast.  Strength in these measures will indicate strong financial health of the corporation and should be considered by business owners, lenders and investors.

The balance sheet will allow a user to gain an understanding of if the corporation has adequate liquidity, is able to pay its debts, fund inventory, collect receivables and make payments on its payables on time.  The aim of management should be to provide confidence the business is able to excel in these areas.

Adequate Solvency & Liquidity

The quick ratio is calculated as:

Current Assets – Inventory

Current Liabilities

The quick ratio illustrates if a corporation is able to meet its obligations over the next year without the risk of inventory becoming obsolete or stale.  A ratio of less than 1.0 is considered a risk, and the higher the number, the better indication of strength in this area.

 

Appropriate Borrowing

The interest coverage ratio is calculated as follows:

Operating Profit

Interest Payments

The interest coverage ratio indicates if a business is earning enough profit to pay its interest expenses comfortably.  While it is prudent to ask a lender what they expect, a calculation of 2.0 or higher in this metric is usually preferred.

Another borrowing calculation is the fixed payment coverage:

Operating Profit + Asset Lease Payments

Interest + Principal + Asset Lease Payments

The fixed payment coverage considers if profits can cover lease payments.  This calculation is usually preferred by lenders to be over 2.0.

Adequate Capital

The debt to equity ratio is calculated as:

Total Liabilities

Owner’s Equity

The debt to equity ratio is a measure of how leveraged the business is.  Lenders tend to prefer a number below 2.0 and the lower the number the better.

Working capital is another measure of adequate capital:

Current Assets – Current Liabilities

The working capital is a measure of liquid assets that are available for the operation of the business.  The higher the working capital, the better the business is able to meet its operational and debt obligations.

Trend Analysis

The growth rate is calculated as follows:

Ending Value – Beginning Value

Beginning Value

The growth rate can be used to determine if certain balance sheet items are increasing, decreasing or stagnant.  Analyzing trends can facilitate further analysis and identify where corrective action is necessary.  For example, an increasing trend for accounts receivable may indicate collections are becoming more difficult and require special attention on collection measures.

How to Cure an Unhealthy Balance Sheet?

Where issues are noted in the above calculations, the symptoms that caused these numbers need to be identified.  Diagnosing the problem will help identify contributing causes.  This should then be followed by an action plan that will include a forecasted plan towards a healthier balance sheet.

Oftentimes issues identified include excessive shareholder draws, capital assets financed by operating cash, poor profitability, payment of obligations too quickly, inadequate efforts in collecting receivables, holding too much inventory and insufficient lines of credits to support growth.

Shajani would be happy to assist with a consulting plan to assess and advise on the health of your balance sheet.

This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. © 2022 Shajani LLP.

Shajani LLP is a CPA Calgary, Edmonton and Red Deer firm and provides Accountant, Bookkeeping, Tax Advice and Tax Planning services.