How to read a business balance sheet

The principle

Assets are resources the business reports, liabilities are obligations, and equity is the residual interest. The basic relationship is assets equal liabilities plus equity. Current classifications help distinguish near-term resources and obligations from longer-term items, although the detailed accounting treatment depends on the applicable standards.

Put it into practice

For a financing discussion, examine cash availability, receivable collectability, inventory quality, and upcoming liabilities. Compare several dates to understand what changed. A rising receivable balance might reflect healthy growth, slower collections, or both. Large shareholder balances deserve explanation because their repayment terms can affect lender analysis.

What people often miss

Book value is not necessarily market value or available collateral. Restricted cash cannot automatically fund ordinary expenses, and old inventory may not realize its stated value. A strong-looking balance sheet also cannot replace the cash forecast. Ask how proposed financing changes leverage, working capital, and the business’s ability to meet obligations as they fall due.

A healthy ratio can conceal a cash shortage

Suppose a fictional business has $20,000 of cash, $60,000 of receivables and $40,000 of inventory. Current assets total $120,000. If current liabilities are $80,000, working capital is $40,000 and the current ratio is 1.5. Neither calculation proves that $80,000 can be paid tomorrow: only $20,000 is cash, and the other assets must first convert into cash on realistic terms.

Now discover that $15,000 of the receivables is disputed and $10,000 of inventory is obsolete. For a management stress test, subtract those amounts from current assets. The adjusted total becomes $95,000 and the ratio approximately 1.19. This is not an accounting entry or a lender's approved borrowing base. It illustrates why supporting schedules and realizable value deserve attention before relying on the headline ratio.

Source: BDC: balance sheet

Trace changes rather than judging one snapshot

Compare the latest balance sheet with the previous year-end and, if seasonal, the same month last year. Mark changes that need an explanation: a line of credit that remains drawn after the selling season, a shareholder advance reclassified as payable, or taxes accumulating while cash remains flat. Match explanations to records. A promised shareholder contribution is different from cash already deposited, and a debt waiver is different from an informal assurance.

For collateral discussions, identify the owner of each asset and the claims already attached to it. A machine used by the company might belong to a leasing company or another group entity. Its book value is also not its liquidation value. Take the same approach to cash: note restrictions and amounts earmarked for imminent payroll or remittances. The useful output is a short list of items that affect liquidity or financing flexibility, plus the documents needed to resolve them.

• Which assets can become cash before the next major bills fall due?
• Which shareholder balances can be demanded or must remain invested?
• Do inventory and receivables schedules reconcile to the ledger?
• What will the proposed financing change on both sides of the balance sheet?

Source: BDC: collateral and security

Your next-step checklist

• Receivables and inventory supporting schedules
• Debt and shareholder-balance details
• Restricted assets and existing security
• Period-to-period changes with explanations