Understand and analyze the balance sheet
- owners’ equity: capital stock, retained earnings, reserve,
- liabilities: accounts payable, loans payable, tax payable.
In the opposite way, more debts part is high more the company depends on them to fund its activity, which can continue only if suppliers and banks credit lines are maintained and raised proportionately with business 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.
This situation can be problematic because the company is dependent on short-term cash credit. Rhe renewal of these credit is not sure. Therefore, the risk of failure increases with this dependence! It may be normal to have recourse to bank credit, but in reasonable proportions.
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!
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.
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.
The interpretation of the balance sheet must be done in parallel with an understanding of the activity of the company, its operating mode, its profitability, its operating cycle, etc. It is taking into account all of the reality of business which makes possible to deduce its solvency, its sustainability and the level of credit limit that can be granted to this company.
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