Going into debt can be perfectly reasonable and desirable for a business if the operations are profitable. Profits from the additional investment will cover borrowing costs, and owners do not have to invest more of their own money in the business. However, going into debt is not always desirable, and too much debt poses a threat to a company’s long-term prospects. The balance sheet provides the best information in the financial statements to identify solvency.
The balance sheet of a company is the financial statement that reflects the situation of a company at the end of a given period. Balance sheets are separated into two halves of the accounting equation: assets on the left, liabilities and equity on the right. In other words, the balance sheet shows what a business has on the left and how it paid for it on the right.
If a company’s assets exceed its liabilities, it is considered solvent. Creditworthiness refers to the ability of a business to pay all of its bills, even at the cost of selling everything off. When a company’s liabilities exceed its assets, it is considered insolvent. While businesses generally want to avoid becoming insolvent, an insolvent business can be very profitable and able to pay all of its bills as they fall due.
Ratios provide valuable information about the health of a business. The debt ratio, total liabilities divided by total assets, indicates whether a business is solvent or not. A ratio greater than 1.0 indicates that liabilities exceed assets and the company is insolvent, and a ratio less than 1.0 indicates that the company is solvent. Other useful ratios for determining whether a business is in operation, a term used to describe businesses that may continue to operate beyond the next 12 months, include current ratio – current assets divided by current liabilities. – and net income in relation to net sales. report.
Balance sheets provide the most useful information to identify a company’s creditworthiness. However, balance sheets reflect the financial position of a business on a specific day. When trying to identify creditworthiness, it is best to have several consecutive balance sheets to perform horizontal trend analysis. Horizontal trend analysis examines how the same measure, such as the debt ratio or the current ratio, has changed over time. When a company’s debt ratio increases month-to-month for several consecutive months, the business may be heading for insolvency. Trends should be seen in the context of other related measures. For example, an increase in the debt ratio is more of a concern when the business operates at a net loss than when the business operates with a net profit and starts with a very low debt ratio.
Biography of the writer
Sean Butner has been writing newspaper articles, blog entries and feature articles since 2005. His articles have appeared on the covers of “The Richland Sandstorm” and “The Palimpsest Files”. He is completing graduate courses in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.