If your wanting to invest in a business then you need an understanding of the companies health. This is done by looking through financial statements. One of these being the balance sheet.
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In today’s post I will be showing you how to read a balance sheet and what it tells you about the company.
What Is a Balance Sheet?
A balance sheet is one way to show how much you owe versus how much you are worth. This financial statement includes both assets and liabilities. An asset is something that you own, such as cash, real estate, cars, furniture, computers, etc. A liability is anything that you owe someone else, such as credit card debt, student loan payments, car repairs, etc.
The balance sheet helps you see where your money goes. If you don’t pay off your debts, it could hurt your personal finances. You might even lose your home.
The Balance Sheet Equation
A balance sheet is one of the most important financial statements because it provides information about how much money you have coming into the future and what you owe to others.
Assets are things like real estate, cars, computers, and furniture; while liabilities are debts such as mortgages and credit card bills. Equity is everything left over after subtracting out both assets and liabilities.
For example, let’s say you have $100,000 worth of assets and $50,000 worth of liabilities. Your net worth is $50,000 ($100,000 — $50,000).
Assets
Assets are the things you own. In the case of a company this will be things such as inventory, buildings, equipment, vehicles, etc.
There are two main categories of assets. These fall into either current (short-term) assets or non-current (long-term) assets. Learn more about them below:
Current (Short-Term) Assets
A current asset is one that can be converted quickly into money. A short-term asset is something you can convert into cash within 12 months.
For example, inventory is considered a current asset because it can be sold quickly. If you sell your inventory, you can use the proceeds to pay off accounts payable.
Accounts receivable represents the balance due from customers; it’s the amount owed to you from someone who bought something from you. You can collect on accounts receivable by selling products or collecting payments.
Non-Current (Long-Term) Assets
A long-term asset is one that you hold for a period longer than 12 months. These assets include things like trademarks, brands, copyrights, patents, licenses, franchises, goodwill, customer lists, etc. You must depreciate non-current assets over their useful lives.
The amount of depreciation expense depends on how much value you place on each type of non-current asset. For example, if you think a trademark is worth $1 million, it might take 10 years to fully depreciate that asset. If you think a brand is worth $100,000, it might take five years to depreciate that asset completely.
Liabilities
A liability is an obligation that needs to be paid back. In accounting terms, it refers to something owed to someone else. For example, you owe money to your landlord because you haven’t paid your rent. You owe money to your creditors because you’ve borrowed money to buy things. And you owe money to your employees because you promised to pay them wages.
In general, companies try to keep their current liabilities lower than their total assets. This helps ensure that there is enough cash flow to cover future payments. If a company has too much debt relative to its assets, it could face financial problems.
Current (Short-Term) Liabilities
The current liabilities section includes short-term debts, such as accounts payable (AP). This category includes bills you owe that must be paid within 12 months. These include payroll expenses, rentcould run out of money before you finish repaying your payments, utility bills, and credit card bills.
Long-term debts are those you owe over one year. They include mortgages, car loans, student loans, and credit cards.
If you don’t pay your bills on time, creditors could take legal action against you. If you’re late paying your mortgage, your lender might foreclose on your home. And if you miss a payment on your credit card bill, the bank could charge interest on the amount you owe.
Non-Current (Long-Term) Liabilities
Long-term liabilities represent obligations that will need to be repaid in more than 12 months. Long-term liabilities include things like pensions, bonds, and other investments. The amount of depreciation depends on how valuable these assets are to you.
You should always have at least enough cash to cover all of your short-term and long-term liabilities. Otherwise, you could find yourself unable to make any payments. If a company is in this position then it creates increased risk of the company going bankrupt if they don’t either lower their liabilities or increase their assets.
Analysing a Balance Sheet with Ratios
A balance sheet is an accounting document that tracks the financial position of a company. In simple terms, it lists all of the company’s assets, liabilities, and equity. This helps investors make decisions about how much money they want to invest in a company.
Ratios are one way we analyze a balance sheet. They provide a snapshot of what a company looks like. For example, the Debt-to-Equity Ratio measures the amount of debt compared to the total value of the company. If you see a high number, it could mean that the company is highly leveraged. On the flip side, a low number indicates that the company is well-capitalized.
The Debtto-Equity ratio is similar to the Debt-to-Capitalization ratio. However, it focuses on the relationship between debt and equity. When the ratio is greater than 2.0, it means that the company is highly levered. Conversely, when the ratio is less than 0.5, it indicates that the company is underleveraged.
Working Capital is another important ratio. It measures the cash flow generated by the company. Companies use working capital to cover expenses such as payroll and inventory. If a company doesn’t generate enough revenue to cover those costs, it won’t be able to continue operating.
Solvency ratios measure the ability of a company to repay its debts. These include liquidity ratios, profitability ratios, and stability ratios. Liquidity ratios look at the short-term availability of funds. Profitability ratios show how efficiently a company uses its resources. Stability ratios examine the risk associated with investing in a company.
A Critical Skill
Financial literacy isn’t just something that helps employees make better decisions. It’s also critical for everyone, including students, parents, and retirees. The ability to read financial statements is one of those skills that we don’t think about but it’s really important, not just for understanding another companies financials, but the same principles can be used to help you understand your own financials.
The problem is, many Americans are woefully ill prepared to deal with basic financial concepts like debt, taxes, and investing. A recent study found that fewer than half of adults could correctly answer questions about personal finance. And according to the National Endowment for Financial Education, less than 20% of high school seniors know what a credit score is.
That’s why the organization launched a campaign called Read & Grow Rich, aimed at getting kids interested in money management early on. “We want to give young people the tools to build good habits around money,” says Baskin. “And we want to teach them how to do it themselves.”
Summary
Balance sheets are essential documents used by accountants to track a company’s finances. The most common type of balance sheet includes three sections: Assets, Liabilities, and Equity. Assets represent everything owned by the company. Liabilities are any obligations owed to creditors or other companies. Equity shows how much money shareholders have invested in the business.
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Comments
Good read