If you want to know the health of a business, understanding balance sheets is very important the balance sheet should be your go-to statement. The balance sheet offers a deep look into how the business is performing. The balance sheet helps investors decide whether or not to invest in a business. Business owners can use the balance sheet to draft a strategy. Employees can also read the balance sheet (if provided access) to improve performance across the organization.
For all this to happen, every individual associated with a business (owners, investors, and employees) should know to read and understand the information in a balance sheet. This piece is a balance sheet 101 for those looking to understand balance sheets. We look at the mechanics and components of a balance sheet.
Let’s Start by Knowing the Balance Sheet
A balance sheet is designed to balance assets, liabilities and equity. Among all the financial documents, a balance sheet tells you about the company’s worth or book value through all the assets, liabilities, and equity. Depending on the preferred frequency, a balance sheet is prepared monthly or quarterly.
What’s the Purpose of a Balance Sheet?
Why does a balance sheet exist, you ask? Simply to offer a summary of a company at any given time. It a 360-degree-look at the financial standing of the organization with the help of a breakdown of assets, liabilities, and equity. The purposes of a balance sheet vary, depending on the person reviewing it.
When reviewed internally by a leader, stakeholder or employee, a balance sheet, simply put, gives an idea of how well or poor the business is performing. Using that information, business decisions can be made to make improvements and correct mistakes and failures.
When an external individual (such as an investor) reviews the balance sheet, the purpose it serves is to provide information on how the company’s assets are financed and what resources are at its disposal. Potential investors can then use this information to assess the outlook of an investment. They can also check up on the liquidity and profitability of the company.
In a third scenario, external auditors review the balance sheet to make sure the company is adhering to reporting guidelines and laws.
Components of a Balance Sheet
It’s easy to identify the components of a balance sheet. There are only two: assets and liabilities. There is a formula that explains a balance sheet in the simplest of ways.
Assets = Liabilities + Equity
This means that a business’s assets must always be equal to the sum of its liabilities and shareholder equity.
But reading and understanding balance sheets isn’t just about knowing the aforementioned equation. To be able to read and truly understand the balance sheet, one needs to know what its elements mean. So, here’s what you need to know to read a balance sheet.
An Understanding of the Types of Assets
There are two major types of assets in any business: current and non-current.
Current assets are items of value a business owns that will be converted into cash in one year. These include:
Inventory: Businesses that sell physical goods usually have finished items, raw materials, and in-progress products
Accounts receivables: A company can have short-term payments that are owed to it. An example of this is a credit sale made to a vendor or customer.
Cash: This includes currency, checks, and bank accounts
In contrast to current assets, non-current assets are those that are acquired or built for the long-term and are not cashable within one year. Tangible and intangible assets are both included in this.
Tangible Assets: A company’s property, equipment, machinery
Intangible Assets: Assets that have to physical presence such as copyrights, patents, and goodwill.
The next step in reading and understanding balance sheets is to know how to examine the business’ liabilities. These are the financial obligations of a business that are owed to suppliers, vendors, and lenders. Similar to assets, liabilities are also current and long-term.
Current Liabilities: These are obligations that are due to be paid within one year. They include short-term borrowings and loans (often regarded as accounts payable) and interest on a long-term loan.
Long-term Liabilities: These include debt and non-debt obligations that are owed and to be paid after one year (from the date of the balance sheet).
Equity (or Capital)
The initial amount of funds that were invested in a business is called shareholders’ equity or capital. When a business decides to reinvest its net earnings (after paying taxes) back into the company, this amount is then entered into the balance sheet and the equity account. As mentioned above, the balance sheet needs to balance. Total assets must always be equal to the sum of total liabilities and equity.
Know the Ratios When Analyzing a Balance Sheet
After you have started understanding balance sheets basics, knowing the importance of financial ratios for greater analysis is necessary. When discussing financial ratios, certain formulas are utilized to understand the position of the business and its operations. These financial ratios are a solid way of knowing the company’s financial performance and efficiency. In certain cases, some financial ratios are calculated using data from multiple financial statements.
The main ratios that utilize information from a balance sheet are activity and financial ratios. Ooof! Heavy words. But let’s simplify them for the sake of clarity.
Activity ratios: These focus on how well a company manages its operating cycle (consisting of inventory, payables, and receivables). You can tell a lot about the business’ operational efficiency through these.
Financial strength ratios: These include debt-to-equity ratios and working capital and offer insight into the performance of the business in terms of its financial obligations.
See Also: Future Of Accounting
A point worth noting about the balance sheet is that it offers an overview of the business’ financial standing at any single point in time.
Similar to the cash flow and income statement, a balance sheet works as an important tool for potential investors looking to pour in funds into the company. The sole purpose of a balance sheet is to provide a glimpse of the assets and liabilities of a business. However, for business owners and investors alike, it is important to understand how to read a balance sheet. If owners and investors are to make informed decisions, knowing the basics of a balance sheet is all too important.