How to Read a Balance Sheet?

Reading a Balance Sheet

Reading and understanding the balance sheet of the company includes consideration of the accounting equation which states that the sum of the total liabilities and the owner’s capital is equal to the company’s total assets, knowing different types of assets, shareholders equity and liabilities of the company and analyzing the balance sheet using ratios.

Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more is the most important financial statement as it helps us see the financial position of the company at a given point in time. It is like a report card to measure a company’s performance.

Balance Sheet, along with the Income Statement and the Cash Flow statement, forms the three primary financial statements in accounting. The Income statement recordsIncome Statement RecordsThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more all the income and expenditure of the business. Then we calculate net profit, which is then included in the Balance sheet under Retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more (in case we do not provide any dividend) to shareholders. The cash flow statement tries to reconcile all the cash-based transactions, and the ending balance of this statement also goes into the balance sheet as “Cash and cash equivalentCash And Cash EquivalentCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation.  Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more.”

How to Read a Balance Sheet

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Source: How to Read a Balance Sheet? (wallstreetmojo.com)

Steps to Read the Balance Sheet of a Company

Balance Sheet reports the amount of a company’s

  • Assets – Current Assets / Long-term assets
  • Liabilities – Current Liabilities/Long-term liabilities
  • Stockholders’ (or owner’s) equity – Common stock / Retained earnings
Balance Sheet Format

Assets = Liabilities + Shareholders’ Equity

It has three main “heads” which are mentioned below along with a brief description of what all items are covered in these heads:

How to Read Balance Sheet Assets?

It includes all the things that the company owns or anything which satisfies 4 attributes which are-future, probable, economic, benefit will come under this head. It is further sub-divided into Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more and Long Term Assets.

Current Assets
Balance Sheet - Colgate - Current Assets

Below are few of the items which generally come under this head:

Long Term Assets
Balance Sheet - Colgate - Long Term Assets 1
  • Plant & Equipment: It shows all the machinery which the company owns to make its products. We also charge depreciation on it to reduce its value over a period of time. Depreciation helps us show the true value of these assets in our business.
  • Then we can have other assets like-land, furniture, vehicles, computers, etc.

How to Read Balance Sheet Liabilities?

It includes the entire amount which the business owes to outsiders. Most of the businesses generally use leverage to increase their profit margin. Leverage is the use of debt to finance our business, thereby reducing the reliance on the owner’s fund to fund the day to day operations of the company. It is further sub-divided into current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more and long term liabilitiesLong Term LiabilitiesLong Term Liabilities, also known as Non-Current Liabilities, refer to a Company’s financial obligations that are due for over a year (from its operating cycle or the Balance Sheet Date). read more.

Current Liabilities
Balance Sheet - Colgate - Current Liabilities

It includes the following items:

Long Term Liabilities
Colgate - Long Term Liabilities

How to Read Balance Sheet Equity?

Colgate - Shareholders Equity

It includes the entire amount which the owner supplies to the business. It includes 2 main items:

The items mentioned above are not exhaustive, and there can be more items that can come under these 3 heads. The main purpose is to highlight the key items which can come under them.

How to Analyze the Balance Sheet?

Apart from that, there are 2 main formats to a balance sheet which we can use to demonstrate this financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, and they are mentioned below:

#1 – Vertical Analysis Balance Sheet

Vertical Analysis - Colgate

In this type of vertical analysis, we look at all the items in the balance sheet as a percentage of total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more. It gives a better graphical representation of how our overall asset base looks like.

#2 – Horizontal Analysis Balance Sheet

In this horizontal analysisHorizontal AnalysisHorizontal analysis interprets the change in financial statements over two or more accounting periods based on the historical data. It denotes the percentage change in the same line item of the next accounting period compared to the value of the baseline accounting period.read more, we look at all the items in the balance sheet in absolute numbers but over a period of time, and hence it is also known as trend analysis. The idea is to see how the company has progressed over a longer period.

Then we also have a common size balance sheetCommon Size Balance SheetThe term "common size balance sheet" refers to a percentage analysis of balance sheet items based on a common figure, with each item presented as an easy-to-compare percentage. For example, each asset is expressed as a percentage of total assets, and each liability is expressed as a percentage of total liabilities.read more, which is more comprehensive and shows items both in absolute and percentage terms over a longer period.

This article has been a guide on how to Read a Balance Sheet. Here we learn how to understand and analyze a Balance Sheet step by step with the help of example and explanations. You may learn more about accounting from the following articles –

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