How to Read the Balance Sheet (The Non Boring Version)
What is a Balance Sheet?
If you find the number riddled, two-column document before you terrifying —don’t worry, its just a balance sheet. Balance sheets exist to show exactly how much a company is worth by dividing its assets between debits and credits and setting them side by side.
If you’re curious about a company’s financial health, there’s no better document than a balance sheet. The form quickly summarizes the company’s financials, and once you understand the terms involved, sifting through it will feel as easy as reading on the beach.
What Can It Tell Me?
Balance sheets are often prepared on abasis and report the state of the company at that time. If you’re an owner, employee, or stakeholder in a company you’ll want to review this document to examine how to correct failures or recommit to winning assets.
Otherwise, if you’re reading the form as a potential investor the balance sheet can tell you what resources a company has and how they were secured. This can show whether investing is a good idea, but it can’t predict the future. By nature, a balance sheet only reports past trends and will not guarantee future success.
The Formula and Its Components
Fundamentally a balance sheet must always strike a balance. As mentioned, the document sets credits and debits side by side —but it’s a little more complicated. On the left, you’ll find the assets which are things of value the company controls. On the right, the form shows who owns these assets. Ownership is split between “liabilities” which are assets owned by someone else and the “owner’s equity” which shows the material wealth possessed by the business owner.
The balance sheet uses a key formula to show the relationship between each of these sections:
Assets = Liabilities + Shareholder’s Equity
No matter what if the form was created correctly this equation will reign true. That being said, whether you’re trying toor just read one, you’ll need to fully understand all the terms involved.
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An asset is anything a company owns with measurable value. If an item can be liquidated and turned to cash within a year it is considered a “current asset”. The most common form is cash or a cash equivalent (like U.S. Treasury bills, or short term investments). These are considered the mostand will appear first on the balance sheet.
Inventory is another form of current asset and refers to the finished goods and raw materials used by a company to make its products. Accounts receivable will also be listed under here and refers to money that is yet to be collected from a sale. Once it is received the amount in accounts receivable will diminish and an equal amount will be added to the “cash” section in the document.
After this come the “non-current” assets. These are long term investments that a company holds but does not aim to liquidate within the year. “Tangible” non-current assets refer to things like property, equipment, and machinery. “Intangible” forms include goodwill, copyrights, and patents. All non-current assets are calculated with depreciation to show their value as it decreases over time.
At their core liabilities are just the opposite of assets. These are financial and legal obligations a company holds, and the amount of money they owe a debtor. Like assets, they’re divided between current and non-current liabilities.
Current liabilities typically refer to amounts that must be paid within one year and can include day-to-day issues like rent payments, payroll, and utility payments. Current portions of long term debt will also be included here though some companies may lump it into accounts payable.
Non-current liabilities refer to long-term obligations a company does not expect to pay off within the year. These can include loans, bonds payable, and deferred tax liabilities. The interest predicted on these amounts must be listed in the balance sheet. When applicable, some companies will also list what they estimate to pay in employee pensions.
Finally, the shareholder’s equity refers to the amount that would remain if all the assets were sold and liabilities paid. It shows the business’s net worth and grows over time as a company continues to reinvest its yearly earnings back into the company.
This amount is technically divided between initial investments made by the owner or shareholders in exchange for shares and the earnings generated by the company’s success. Comparing balance sheets over time can help you differentiate between these amounts and predict the business’s trajectory.
Understanding The Formula
If you’ve gotten this far you’re going to be fine. Once you can identify the difference between assets, liabilities, and equity it’s just a matter of understanding a business’s control of each. Remember that no matter, what a correctly compiled balance sheet will always show:
Assets = Liabilities + Shareholder’s Equity
Another way to think about this is that all the assets in a company are either owned by a creditor (liabilities) or the company itself (shareholder’s equity). The balance sheet just exists so you can compare how much the company owes vs. how much it’s grown its investments.
Crunch The Numbers
If you’reand finding the math isn’t adding up, many miscalculations are just due to doubled or forgotten assets, issues in reporting inventory, or loan amortization or depreciation. Otherwise, if you’re just trying to read one it can be helpful to run through a few examples.
Owner’s equity = Assets – Liabilities
Remember that for the initial formula to hold true, its inverses must as well —but don’t stress! This is easier than it sounds, and there are even onlinethat can help you drill through a sample balance sheet so you understand every aspect of it. Then once you’re confident in your skills go ahead, bring those balance sheets to the beach.