The Balance Sheet and Financial Strength

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The Balance Sheet and Financial Strength

The balance sheet is a summary of an organization's assets, liabilities and shareholder's equity at a point in time. This also can be called a statement of financial position because it outlines the organizations capital (assets), debts (liabilities) and the investor's contributions (shareholder's equity). Each of these can have several accounts within each segment. Assets can be considered as cash, accounts receivable, merchandise inventory and property while liabilities can be accounts payable, short-term debt and long-term debt. The balance sheet is base on a fundamental equation, which is expressed as:

Total Assets = Total Liabilities + Owners' Equity

This equation shows that the assets must equal the liabilities plus the owners' equity of the company.

The balance sheet provides a column for assets and a column for liabilities and owners' equity. The first item under the assets column of the balance sheet is current assets. Current assets are considered assets on the balance sheet, which can be converted into cash in the near future, usually within one year. These assets are considered to be "liquid" assets and include cash, accounts receivable and merchandise inventory.Following the current assets on the balance sheet are items that are not considered liquid assets. Plant equipment and accumulated depreciation are considered noncurrent assets.

The first item in the liabilities and owners' equity column is the current liabilities. Current liabilities are debts, which are expected to be settled within one year of the balance sheet date. This includes short-term debt and accounts payable.The next item in the liabilities column are the noncurrent liabilities, which include long-term debt. This is typically amounts borrowed from banks that won't be paid within the year of the balance sheet. The current and noncurrent liabilities will be totaled together to give total liabilities. The next item on the balance sheet is owners' equity and this totaled with the total liabilities completes the right side of the equation. This amount should always equal the total assets side of the balance sheet.

Aside from illustrating the assets, liabilities and owners' equity of a corporation, a balance sheet can provide information about their financial strength. One calculation that can be made is working capital. Working capital determines what the overage would be if the corporation accumulated all its current assets and paid all its current liabilities. The expression for working capital is:

Working Capital = Current Assets Current Liabilities

A positive working capital indicates that the company is able to meet its short-term debt and operating expenses. A company can find themselves with a poor working capital if they have considerable short-term debt. In this situation, poor working capital could lead to increased borrowing or late payments, which could affect their future ability to borrow. Some companies strive for a low working capital, like a grocery store. In this case, the current assets are received very quickly and the revenue is used to purchase new inventory.

Another determination of a corporation's financial strength is current ratio. Current ratio is the financial ratio that measures if a firm has enough resources to meet its current liabilities and obligations with its available current assets. The higher the current ratio the more likely the firm will be able to meet their obligations and is considered more financially strong. It is expressed as the following:

Current Ratio = Current Assets / Current Liabilities

Although current ratio is a good indication of financial strength, there is another ratio that is more telling of liquidity. The acid-test ratio or quick ratio is an expression that shows whether a company has enough current assets to pay its immediate liabilities without including inventory as an asset. It is expressed as the following:

Acid-Test Ratio = (Current Assets Total Inventory) / Current Liabilities

The acid-test ratio is more strenuous than the current ratio, mainly because the current ratio allows for the inclusion of inventory. Companies with acid-test ratioslower than 1 may not be able to pay their current liabilities and may be considered risky by creditors or investors, although the risk is dependant on the industry. As discussed earlier, some industries survive on low working capital and ratios close to 1. Furthermore, if the acid-test ratio is much lower than the current ratio, it means current assets are dependent on inventory.

We can use an example within the power generation industry and use numbers from a 2009 balance sheet. The following amounts are in millions of dollars (USD) and is public information found in the financials section of the corresponding investors page.

Company Exelon NRG

Net income...$2706.00...$ 942.00

Current Assets.$ 5441.00.$ 6208.00

Current Liabilities$ 4238.00.$ 3762.00

Total Inventory.$ 757.00..$ 541.00

Working Capital... $1203.00... $2446.00

Current Ratio...1.28...1.65

Acid-Test Ratio....1.11......1.51

As can be seen by the above example, Exelon had significantly more net income than NRG but after the financial equations were calculated, NRG had a stronger working capital and their ratios were higher.

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