Financial Statement Series: What is the Balance Sheet and why should you care?
- Rylan Kaliel
- Feb 10
- 5 min read
Updated: Apr 11
I could spend a lot of time and use a lot of big accounting words to explain what the Balance Sheet is. But let’s be honest, you can just Google the concept and get an AI-generated explanation full of jargon. Instead, let’s demystify the concept in a way that makes sense without unnecessary complexity.
What is a Balance Sheet and Why Does It Matter?
The Balance Sheet provides a snapshot of your business’s financial position at a specific moment in time. You might wonder why I emphasize "a moment in time"—this is because the Balance Sheet tracks the increase or decrease of your assets, liabilities, and equity since your business started. Unlike an Income Statement, it never resets.
Breaking Down Current Assets on the Balance Sheet
In the first installment of our Financial Statements blog series, we will focus on current assets. You’ve probably heard the phrase “cash is king”—well, the Balance Sheet agrees!
The first section of a well-structured Balance Sheet details liquid assets such as cash, accounts receivable, inventory, and short-term investments. These are the assets that can be quickly converted into cash to cover liabilities if necessary.
Evaluating the Quality of Your Current Assets
Not all assets are created equal. As your business grows, you should consistently evaluate the quality and viability of your assets to avoid financial pitfalls. Let’s break down key considerations for each category.
Cash: The Lifeblood of Your Business
Ask yourself:
Is my cash worth what it says its worth? Are there external factors that may affect the value of my cash?
What if I buy from a foreign country? Let’s say that you have Canadian dollars, but you purchase things in the US using US dollars. If the exchange rate changes and Canadian dollars are now worth less US dollars, you will need more Canadian dollars to pay for the same amount of goods.
Accounts Receivable: Will You Actually Get Paid?
Before assuming all accounts receivable ("AR") will convert into cash, ask:
Will I get paid? Will I be able to collect this money?
How long until I get paid? How long does it take my customers to pay? If it takes 90 days to collect, but you must pay vendors in 30 days, you might face a cash flow crunch.
Inventory: A Business’s Greatest Asset (or Liability)
Inventory in many ways is the life blood of your business. What you sell and how you sell it is what differentiates you as a business from all others. There are a few things that you should keep in mind about your inventory as you seek to progress in business. Consider:
Is there demand? The first thing is, does anyone want to buy my inventory, because if the answer to that question is no, then you really don’t need to look further.
Does it expire? The second question you need to ask yourself is, is my inventory perishable and will I be able to sell it before it expires. If you don’t believe you can sell it by the time it will perish then you might want to look at ways to move it such as holding sales or writing it off.
How liquid is it? Can you quickly turn it into cash when needed? If your inventory takes a long time to sell, this could turn into a problem if you also need cash.
Short-Term Investments: Risk vs. Reward
Investments can provide returns, but they also carry risk. Ask yourself:
Are my investments worth what they say they are? The stock market is a volatile beast, so you need to make sure that your investments are worth what you are recording them as.
Should I seek professional guidance? If you are not very familiar with the stock market it might be prudent to go to professionals to help you with investments or just to hold on to the cash instead.
Key Ratios to Analyze Current Assets
Now that we understand current assets, let’s explore key financial ratios that measure their viability.
Accounts Receivable Ratios
The two most common ratios used to see how well you are managing your AR are account receivable turnover and days in receivables.
Few key things to note before diving in. Credit sales are sales you didn’t receive cash for (yet). The beginning and ending account receivable for the period are, surprisingly, how much your accounts receivable were at the beginning and ending of the period.
Accounts Receivable (AR) Turnover Ratio
This ratio shows you how many times during that period your AR was converted to cash. Let’s work through an example to see this in action.
Formula: Total credit sales / Average accounts receivable
Example Calculation:
Credit sales: $20,000
Beginning AR: $5,000
Ending AR: $2,000
Average AR: (5,000 + 2,000) / 2 = $3,500
AR Turnover: 20,000 / 3,500 = 5.71
So, what does the 5.71 mean? This means your receivables converted into cash 5.71 times during the period.
Days in Receivable
This ratio shows you how many days it took for your AR to be converted to cash. Afterall, 5.71 doesn't tell us a lot, we aren't shouting from the rooftops we have a AR turnover of 5.71, are we? Let’s work through an example to see this in action.
Formula: 365 days / AR turnover
Example: 365 / 5.71 = 64 days
On average, it takes 64 days to collect payments. That makes a lot more sense to us, at least!
Inventory Ratios
There are a number of ratios that can be used to analyze inventory, however, most of them can be very complicated and are best discussed further down the road. At this time let’s focus on the most common ratio used which is the inventory turnover ratio (surprisingly, not that different from the AR turnover ratio).
Inventory Turnover Ratio
The two most common ratios used to see how well you are managing your inventory are inventory turnover and days for inventory turnover.
Few key things to note before diving in. Cost of good sold are the costs associated with production of the inventory which can include both variable and fixed costs. This will be discussed in-depth in our discussions surrounding the income statements as it is a very nuanced concept.
As a side note, it is advisable to get a professional accountant involved in the calculation of the cost of good sold as an error in its measurement can have serious consequences for a business.
Formula: Cost of goods sold / Average inventory
Example Calculation:
Cost of goods sold: $15,000
Beginning inventory: $10,000
Ending inventory: $8,000
Average inventory: (10,000 + 8,000) / 2 = $9,000
Inventory turnover: 15,000 / 9,000 = 1.66
Again, what does the 1.66 mean? This means that you sell and replenish inventory 1.66 times per period.
Days for Inventory Turnover
This ratio shows you how many days it took for your inventory to be converted to revenue. Similar to the above, 1.66 doesn't tell us a lot, still not shouting from the rooftops, so let's make it simpler.
Formula: 365 days / Inventory turnover
Example: 365 / 1.66 = 220 days
On average, it takes 220 days to sell your entire inventory.
Conclusion: Strengthen Your Financial Health
Understanding your Balance Sheet, current assets, and key financial ratios helps you make informed decisions for business growth. Regularly evaluating cash flow, accounts receivable, inventory management, and short-term investments ensures your company stays financially healthy.
Stay tuned for the next in our Financial Statement Series where we will discuss current liabilities, every businesses favorite enemy.
Need professional accounting guidance? KLV Accounting is here to help. Contact us today to enhance your financial strategy and drive business success!
For a free consultation, call us at 403-679-3772 or email us at info@klvaccounting.ca.
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