Reading the Balance Sheet

Reading the Balance Sheet

A balance sheet, often known as a “statement of financial position,” shows the assets, liabilities, and equity of a company (net worth). The balance sheet is the cornerstone of any company’s financial statements, together with the income statement and cash flow statement.

It’s critical to understand how a balance sheet is built, how to analyze it, and how to read it if you’re a firm shareholder or a potential investment.

How to Read a Balance Sheet

The balance sheet is separated into two portions that must equal or balance each other based on the following equation. A balance sheet’s main formula is as follows:

Liabilities + Shareholders’ Equity = Assets

This indicates that a firm’s assets, or the methods by which it operates, are balanced by its financial responsibilities, as well as the equity investment made in the company and its retained earnings.

A company’s assets are what it utilizes to run its business, while its liabilities and equity are the two sources of funding for these assets. In a publicly listed corporation, owners’ equity, also known as shareholders’ equity, is the amount of money initially invested in the company plus any retained earnings, and it serves as a source of finance for the company.

A balance sheet is a snapshot of a company’s financial status at a specific point in time.

Understand the Different Asset Types

Assets in Use

Current assets have a one-year or shorter lifespan, which means they can be easily converted to cash. Cash and cash equivalents, accounts receivable, and inventories are examples of asset classes.

Cash, which includes non-restricted bank accounts and checks, is the most basic of current assets. Cash equivalents, such as US Treasuries, are extremely safe assets that can be easily changed into cash.

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Clients owe the company short-term commitments, which are referred to as accounts receivables. Customers are frequently sold things or services on credit, and these liabilities are retained in the current assets account until the clients pay them off.

Finally, inventory refers to the raw materials, work-in-progress commodities, and finished goods held by the company. The inventory account’s actual makeup will vary depending on the company. A manufacturing company, for example, will have a big inventory of raw materials, whereas a retail store will have none. The majority of a retailer’s inventory is made up of items bought from manufacturers and distributors.

Non-current assets are assets that are not in use right now.

Non-current assets are assets that can’t be quickly converted to cash, aren’t projected to be converted into cash within a year, and/or have a longer life expectancy than a year. Machines, computers, buildings, and land are examples of tangible assets. Intangible assets, including as goodwill, patents, and copyright, can also be considered non-current assets. While these assets are not tangible, they are frequently the resources that can make or destroy a business—the importance of a brand name, for example, should not be overlooked.

Most of these assets have depreciation applied to them, which represents the asset’s economic cost throughout its useful life.

Understand the Various Liabilities

Liabilities are on the other side of the balance sheet. These are a company’s financial commitments to third parties. They, like assets, can be both short-term and long-term.

Debts and other non-debt financial obligations that are due after a period of at least one year from the balance sheet date are classified as long-term liabilities. The company’s current liabilities are those that will be due or must be paid within one year. This comprises both short-term borrowings like accounts payables and the current portion of longer-term borrowings like a 10-year loan’s latest interest payment.

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Equity of Shareholders

The initial amount of money invested in a corporation is referred to as shareholders’ equity. If a corporation decides to reinvest its net earnings (after taxes) in the company at the end of the fiscal year, these retained earnings are transferred from the income statement to the balance sheet and into the shareholder’s equity account. The complete net value of a corporation is represented by this account. Total assets on one side must equal total liabilities plus shareholders’ equity on the other side for the balance sheet to be balanced.

Check out a Balance Sheet

Here’s an example of a Walmart corporate balance sheet from around 2016:

The balance sheet above shows that it is divided into two primary divisions. The company’s assets are on top, followed by its liabilities and shareholders’ equity. This balance sheet is likewise in balance because the value of the assets equals the total value of the liabilities and shareholders’ equity.

The balance sheet’s organization is another fascinating feature. The balance sheet’s assets and liabilities parts are arranged according to the account’s present status. On the asset side, accounts are often categorized from most liquid to least liquid. The accounts for liabilities are ordered from short-term to long-term borrowings and other obligations.

Ratio Analysis of a Balance Sheet

We may explore several approaches used to analyze the information included within a balance sheet once we have a better knowledge of what a balance sheet is and how it is generated. Financial ratio analysis is the main technique.

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Formulas are used in financial ratio analysis to get insight into a company’s operations. Using financial ratios (such as the debt-to-equity ratio) on a balance sheet can give you a solid idea of the company’s financial situation as well as its operational efficiency. It’s worth noting that some ratios will require data from multiple financial statements, such as the balance sheet and income statement.

Financial strength ratios and activity ratios are the two most common types of ratios that employ data from a balance sheet. Working capital and debt-to-equity ratios are examples of financial strength measurements that show how well a company can meet its obligations and how leveraged those obligations are.

This might provide investors an understanding of the company’s financial stability and how it finances itself. Activity ratios are primarily used to assess how successfully a company manages its operational cycle (which include receivables, inventory, and payables). These figures can reveal information about a company’s operational efficiency.

Final Thoughts

Investors use the balance sheet, together with the income and cash flow statements, to acquire insight into a company’s activities. It’s a snapshot of the company’s accounting at a particular point in time, including assets, liabilities, and shareholders’ equity.

A balance sheet’s aim is to show what the firm owns and owes, as well as to provide interested parties a sense of the company’s financial status. All investors should understand how to utilize, analyze, and read a balance sheet. A balance sheet can provide information or justify an investment in a stock.

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