How to Read a Balance Sheet

The first thing to remember about a balance sheet is that it is a snapshot of a company financial condition a specific point in time. A balance sheet is usually comprised of three sections (assets, liabilities and owners equity). So first let’s understand what each of these parts are.

The asset section of the balance sheet seeks to compile a list of all items a company owns that can be calculated in monetary terms.

Current assets – These are the assets that can be readily turned into cash within one year.

1) Cash – This is for the most part self explanatory

2) Accounts receivable- These are the amounts owed to the company by people who have purchased with credit extended by the company. Accounts receivable will many times be offset by an allowance for a percentage that may never be collected (Allowance for doubtful accounts)

3) Short term investments

4) Prepaid expenses. Prepaid expenses are item you pay in advance for future benefits. A good example is a yearly insurance policy. The closer you get to the end of the year the less the policy is worth.

5) Inventories include raw materials, work-in-progress and the final product. In a retail business it will include items bought for resale.

Property plant and equipment (Fixed assets) – These are assets that are not liquid and cannot be converted into cash easily.

1) Equipment, buildings, land, automobiles etc

2) As most of these items also are subject to wear and tear and loss of value as they age there will usually be accumulated depreciation accounts. These represent a systematic method for keeping track of the decline in value.

Other assets – Basically these are assets that do not fit in the other classifications. Examples can be:

1) Intangibles that were purchased such as goodwill

2) Investments that are held for long term

3) Cash reserves set aside for future needs

4) Intangibles and long term investments sometimes are classified separately on the balance sheet

The liability section of the balance sheet seeks to list all amounts owed by a company.

Current liabilities- These are the liabilities that are due within one year. Examples are

1)Accounts payable – These are the amounts typically owed to supplies for items that were bought on account.

2) Notes payable – Promissory notes to creditors.

3) Current portion of long term debt. The common example of this is the portion of a mortgage that is due in the current year.

4) Unearned Revenue – Payment received on goods that are not yet delivered or finished.

Long Term liabilities – Conversely these are liabilities not due within one year. Examples are:

1) Mortgages payable, bonds payable and long-term notes.

Owners Equity is the difference between assets and liabilities.

1) This is also referred to as the book value. Book value is a good conservative measure of a company’s value. But usually the actual value can be different. Assets especially property, plant and equipment are probably worth more or less than their book value.

2) Retained earnings is a measure of what has been earned by the company over time but not distributed to the shareholders or owners.

Once you have a good understanding of what makes up the balance sheets you can then use the tools for analyzing it. The main tools are financial ratios. Financial ratios are usually more powerful when compared to other companies in your industry. Here are the most common used ratios for balance sheets.

Current Ratio – This is calculated by dividing current assets by current liabilities. It gives a good measure of a company’s ability to meet it current obligations. A ratio of 1 indicates there is just enough to cover current liabilities in an emergency. Typically the higher the number the better although in some industries too high of a number could indicate you are not using credit extended by suppliers well.

Quick Ratio – This is almost the same as the current ratio except inventories are removed from current assets. This is because many times inventories cannot (or should not) be converted to cash very quickly.

Working Capital – This is calculated by subtracting current liabilities from current assets. This is also a good indicator of the financial strength of a company.

Debt to Equity Ratio – This is calculated by dividing total liabilities by shareholders equity. This ratio show the relationship between how much of a company’s assets were acquired internally (from stockholders) or externally (through debt).

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