Understand and analyze the balance sheet

The balance sheet is a snapshot of a company's financial condition. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. The balance sheet shows if company's activity is mainly financed by:

owners’ equity: capital stock, retained earnings, reserve,
liabilities: accounts payable, loans payable, tax payable.

The higher the part of owners’ equity is high in comparison with debts, the more the company is financially autonomous, therefore solvent.

In the opposite way, more debts part is high more the company depends on them to finance her activity, which can continue only if suppliers and banks credit lines are maintained and raised proportionately with company growth.

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What is the balance sheet?

Assets are divided into two parts :

current assets: accounts receivables, inventory, work in process, cash, etc., that are constantly flowing in and out of a firm in the normal course of its business, as cash is converted into goods and then back into cash,
fixed assets: land, buildings, equipment, machinery, vehicles, leasehold improvements, and other such items. Fixed assets are not consumed or sold during the normal course of a business but their owner uses them to carry on its operations.

If we look to the company's financial resources (owners’ equity + liabilities) and the assets, we can determine the part of the owner’s equity which finances the current assets; in other words the business activity of the business. This is the working capital.

If working capital is weak, working capital requirements is financed by the liabilities (negative treasury). In this case, the company is financialy weak and depends on its creditors (banking, suppliers) to maintain and develop its activity.

Dynamic view of the balance sheet: the working capital and the working capital requirements

How to calculate the working capital requirement?

Working capital: equity- fixed assets.
The WC must be positive and large enough to cover the WCR.

If the WC is negative, that means that equity is not sufficient to finance fixed assets and the company has recourse to the short-term bank loan (whose renewal is not guaranteed) to finance it. The default risk is maximal!

Working capital requirement: Operating assets (inventories + accounts receivables) - operating liabilities(payables).
The WCR represents the need to finance the operation. It depends strongly on the sector of activity. For example, industrial companies generally have a higher WCR while the major retailers have a negative working capital (they are paid by their customers before they pay their suppliers).

Net cash: WC - WCR.
The Net cash is the remaining of WC after absorption of WCR. If the WC covers WCR, the net cash is positive. This amount is reflected in cash (excess cash on a bank account).

If the WC does not cover the WCR, net cash is negative. Stable financial resources are insufficient to finance the activity and the company has recourse to the short-term bank loan or credit suppliers to finance the operating cycle.

This situation is problematic because the company is dependent on credit given by suppliers or / and short term loans which renewal is not assured. The risk of failure is high even if many businesses are in this case!

Be careful with companies having an unbalanced financial structure with an even negative WC and a high WCR. This is a consequence of a bad management or a too light financing. These situations make these companies very risky whatever is the good will of the leaders to respect their commitments.
Tensions of treasury are almost systematic and the risk of delays of payment or unpaid invoices is very high. A turnover decrease, an unpaid invoice or a disengagement from a creditor (banks, supplier) can be fatal and lead the company to the bankruptcy.

Analyze the financial structure as a whole and in a dynamic way.
Each case is particular and the evaluation of the assessment depends intrinsically on the company business sector and of the financial need which results from this.
Thus, a simple trade has to finance mainly its stock when an iron and steel company must finance very heavy fixed assets (equipment, grounds. .etc), stock and credits allowed to customers.

Next: The Tangible Net Worth

Last comments

	Quick & simple One of the Best interpreattions!!
From :	Heena Chirania /

	Well explained.... Nicely presented
From :	Ajay Kamath /

	Wow! Easy to follow and understand. Thank you.
From :	Jane /

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