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 Sheet 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 records all the income and expenditure of the business. Then we calculate net profit, which is then included in the Balance sheet under Retained earnings (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 equivalent.”
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
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 Assets and Long Term Assets.
Current Assets
Below are few of the items which generally come under this head:
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- Cash: It shows the cash balance of the company, be it the physical cash that they hold or the bank balance.
- Marketable Securities: Marketable Securities include the short investments that the company has made. They can be in the form of bond investment or capital stock of other companies. These investments can come in handy when we don’t have sufficient capital because they have high liquidity and can convert into cash very easily.
- Account Receivables: Accounts Receivables are nothing but credit sales which the company has made. It is an asset because the company has made the sale but is yet to receive the money.
- Inventory: Inventory is the stock of the company.
- Prepaid expenses and accrued income: Sometimes, the business needs to incur certain prepaid expenses before they can receive any product. E.g., cash paid for advertisements. However, the benefit from it will accrue over a period of time. Similarly, we can have accrued income, which is income earned but not received. So we can recognize such income in the current fiscal year regardless of whether received or not. So it will be like accounts receivables, and we are assured of receiving our money in the future.
Long Term Assets
- 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 liabilities and long term liabilities.
Current Liabilities
It includes the following items:
- Accounts Payables: Accounts Payable is the total amount which the company owes to its suppliers for supplying the raw material or goods to the company. Most of the industries work on trade credit wherein they provide some leeway to the buyer to make the payment, thereby giving him time to arrange the funds. It helps in boosting the sales of the business as they can make sales to those customers as well who don’t have the money to pay upfront but will pay the money in the near future.
- Unearned Revenue: Unearned revenue is just the opposite of Accrued income. In this case, we have received payment from our customers, but we are yet to deliver the goods. So it becomes a short term liability until the delivery of goods.
- Current portion of long term debt: CPLTD includes all the debt payments which are accruing within a year.
Long Term Liabilities
- Long term debt: Long Term Debt includes the amount which we have raised for longer duration and thus forms a critical part of our capital structure as well.
How to Read Balance Sheet Equity?
It includes the entire amount which the owner supplies to the business. It includes 2 main items:
- Paid-up Capital: Paid-up Capital includes the core capital of the business. In large businesses, it can be further segregated into common stock and preferred stock. In preferred stock, we tend to get preference over common stock in terms of dividend payment, but they do not have any voting rights, whereas common equity forms the base of the capital structure for the company.
- Retained Earnings: It provides a snapshot of the entire amount which the owners have earned and reinvested in the business instead of taking the dividend.
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 statement, and they are mentioned below:
#1 – Vertical Analysis Balance Sheet
In this type of vertical analysis, we look at all the items in the balance sheet as a percentage of total assets. It gives a better graphical representation of how our overall asset base looks like.
#2 – Horizontal Analysis Balance Sheet
In this horizontal analysis, 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 sheet, which is more comprehensive and shows items both in absolute and percentage terms over a longer period.
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