This article delves into the Analysis of the Balance Sheet, also known as the Statement of Financial Position. It offers recommendations on leveraging this financial document to interpret the organization’s financial performance and uncover emerging trends.
Statement of Financial Position or a Balance Sheet is a financial statement that provides a snapshot of an organization’s financial position at a specific point in time, listing its assets, liabilities, and shareholders’ equity or net assets (for non-profits).
Unlike the income statement, which spans a period, the balance sheet is confined to a particular date, indicating the existence of balances at that precise moment. For example, the cash balance reflects the amount of cash the organization holds as of December 31, delineating a specific date rather than a cumulative timeframe.
Liquidity Analysis:
When initiating the analysis of the statement of financial position, begin by examining the organization’s liquidity, as reflected in cash and cash equivalents. Calculate the average days of cash on hand by dividing the cash balance by the average monthly expenses. You have the flexibility to use either the actual expenses or the budgeted monthly expenses, depending on your preference.
Alternatively, daily cash on hand can be determined using the following formula:
- A) Daily cash requirement = (Annual expense budget less non-cash expenses like depreciation and amortization) ÷ 365 days
- B) Daily cash on hand = Cash and cash equivalents ÷ Daily cash requirement
This valuable financial indicator offers insight into the number of days an organization can sustain its core operations in the event of an unexpected interruption to cash inflow, typically derived from revenue.
The optimal level of liquidity for an organization hinges on its unique needs and cash management strategies. As a general guideline, we recommend that organizations maintain a cash reserve equivalent to three to six months of operating expenses.
Assets Overview:
Subsequently, shift your focus to reviewing current assets (cash, accounts receivable, inventory, etc.).
Organizations must convert current assets into cash efficiently. Conduct a thorough analysis of the quality of accounts receivable by examining accounts receivable aging. The longer receivables remain outstanding, the higher the likelihood of non-collection. We advise concentrating on receivables outstanding for 90 days or more and trying to collect them as soon as possible. Calculate the AR aging ratio by dividing accounts receivable over 90 days overdue by the total accounts receivable. Calculating the AR ratio allows organizations to track trends in changes in AR over 90 days, regardless of the size of the overall AR, reflecting shifts in the overall AR portfolio.
Next, shift your focus to non-current (property, equipment, lease-hold improvements, long-term investments, and other assets that are not anticipated to be converted into cash within one year) or fixed assets.
Financial statements typically present fixed assets net of accumulated depreciation. Examine the gross amount before and accumulated depreciation separately. If the assets are nearly fully depreciated, this could be an indication or sign that it’s time to consider replacing your capital assets. Such a decision might necessitate additional cash resources. For example, let’s consider an organization that owns furniture and office equipment purchased for $150,000, with a useful life of 60 months or 5 years. At the end of the fourth year, the Statement of Financial Position will show the following balances: Furniture and Equipment $150,000, Accumulated Depreciation ($120,000), Net Fixed Assets $30,000. These numbers suggest that the furniture and equipment are nearing the end of their useful life and may need replacement.
Liabilities and Net Assets Analysis
Proceed to the review of the liabilities and net assets section of the statement of financial position. Begin by scrutinizing current liabilities (accounts payable, payroll taxes, accrued expenses and other short-term debts due for payment within 12 months) and assess their consistency from one period to the next. Ensure that the organization is equipped to meet its current obligations. Utilize financial ratios such as the current and quick ratios for this analysis. The formulas for these ratios are as follows:
Current ratio = Current assets / Current liabilities
Quick ratio = (Current assets – Inventory) / Current liabilities
Typically, a current ratio of 1.5 or higher and a quick ratio of 1 or higher are considered favorable indicators of financial health. The quick ratio, being more conservative, considers highly liquid assets like cash and receivables while excluding inventory.
Then review long-term liabilities (long-term loans, deferred tax liabilities, long-term lease obligations, and other debts due in more than 12 months).
Investigate trends and observe if they are increasing as a proportion of total assets from one period to the next. Understand the nature of the items reported as long-term liabilities and gain insight into the organization’s plans to settle them in the long term.
Finally, conduct a thorough review of the net asset section of the statement of financial position.
Net assets represent the residual balance in the organization’s assets after meeting all obligations. The net income or loss for the period (typically a year) influences the increase or decrease in the organization’s net assets. For non-profits, it’s critical to analyze the composition of net assets and understand what portion is unrestricted and restricted. Unrestricted assets are under the full discretion of management, while restricted assets have funder-imposed restrictions.
~Imran Babayev, CPA
The Consonance Group provides expert level financial management for small non-profits and for-profit organizations. Please reach out to Jonathan at jonathan@consonance.group.