How to Use a Balance Sheet to Run Your Business
Why the Balance Sheet?
The Balance Sheet is a standard financial report that helps you evaluate your business' credit/liquidity risks, and it also shows you your book value, which is a measure of worth. Let's look at each one of these components separately, through the lens of the following equation:
Assets = Liabilities + Equity
Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. Whenever your company takes on debt to finance operations or to make investments, it will have to pay interest on the principal outstanding at some agreed upon rate. The interest payments will appear on your Profit and Loss statement as an operating expense and it must be paid timely, irregardless of your business' performance. If you find it difficult to cover your interest payments, your business faces credit/liquidity risk.
To manage your business' credit risk appropriately, you'll want to review your Balance Sheet periodically to calculate a figure called the Current Ratio. According to investopedia, the current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year. Liz breaks down how to calculate the current ratio in the video.
The book value of a company is the total value of the company's assets, minus the company's outstanding liabilities. Book value is a measure of worth. CEO's should look at the Balance Sheet to monitor worth, not as a vanity metric but as a measure of solvency. In the video, Liz breaks down the debt to equity ratio. The debt-to-equity ratio helps in measuring the financial health of a company since it shows the proportion of equity and debt a business is using to finance its assets.