Your balance sheet is a summary of your assets, liabilities and equity capital at a given point in time, usually 31 December. It serves as a snapshot of the current state of your business. This is presented schematically in the form of a balance sheet.
||Liabilities and shareholders' equity
|Non-current assets (fixed assets)
|Cash and cash equivalents (readily available)
Profit and loss (P&L) account
Your P&L account summarises your business's income and expenditure for the year, and shows whether your business has made a profit or a loss. Smaller businesses don't have to publish their P&L accounts.
Cash and cash equivalents (or liquid assets) consist of cash (currency, coins and notes), bank money (demand deposits) and petty cash. A cash flow statement clarifies how much money enters and leaves your business over the course of the financial year.
Financial assessment and ratios
Financiers have to assess your business's financial situation before they'll extend any form of credit. They need to know whether your business can meet all its payment obligations and whether it makes for an interesting investment proposition. Ratios are used to determine your business's financial position. The most commonly used ratios are liquidity, solvency and profitability.
Liquidity is the extent to which your business is able to meet its short-term payment obligations. Three ratios apply:
- Current ratio
- Quick ratio
- Net working capital
This ratio measures whether or not your business has enough resources to pay its debts over the next twelve months. It is expressed as follows:
Current ratio = Current assets / Current liabilities
A healthy ratio value is greater than 1. An average value for businesses lies between 1.2 and 1.5.
This ratio measures whether or not your business has enough resources to pay its debts over the next twelve months. It differs from the current ratio because it excludes inventories from the calculation. It is expressed as follows:
Quick ratio = (Current assets – inventories) / Current liabilities
A healthy ratio value is greater than 1.
Days sales outstanding (DSO or days receivable) and days in inventory (or days inventory outstanding or inventory period) are also important factors.
Days in inventory measures the average number of days your business holds its inventory before selling it. This is usually between 30 and 90 days depending on the sector or industry. It is expressed as follows:
Days in inventory = inventory × 365 / cost of goods sold (COGS)
Days sales outstanding (DSO) measures the average collection period for your accounts receivable. This is usually between 30 and 60 days. It is expressed as follows:
Days sales outstanding = (Accounts receivable × 365) / Turnover
Net working capital
Working capital is the difference between current assets and current liabilities on a business's balance sheet. It is expressed as follows:
Net working capital = Current assets – Current liabilities
Net working capital is healthy when current assets exceed current liabilities over the short term.
Solvency is the ratio of equity to capital required. It indicates the extent to which your business can meet its long-term debts. It is expressed as follows:
Solvency = (Owners' equity / Total assets) × 100%
Banks often require that you put at least 20% of your own equity into the business as a start-up. In some sectors, e.g. hospitality, it can be as much as 50%.
Profitability compares the trading profit to the average total investment. This provides an indication of your business's success. It is expressed as follows:
Profitability = (Business profit / Average total investment) × 100%