What is a balance sheet?
Balance sheets are just one of the three financial statements that make up an organization’s total finances. Along with income statements and cash flow statements, they help to paint a complete picture for investors on how their investments in companies or other organizations turned out over time.
A balance sheet is a statement of financial position that displays how much of what you own and owe.
A typical balance sheet has three columns: Assets, Liabilities, and Equity; with each column being further divided into various categories.
What are Assets?
1. Assets are things that belong to the company.
2. Examples of assets include cash, inventory, buildings, and equipment
3. Assets can be classified as current or non-current based on how quickly they can be converted to cash. We will go into more detail about this later.
What are Liabilities?
1. Liabilities are things that a company owes to others such as suppliers, insurance companies, etc
2. Examples of liabilities include accounts payable, unpaid taxes, and notes payable
3. Liabilities can be classified as current or non-current based on how quickly they are expected to be settled or paid out. We will talk about this later.
What is Shareholders Equity/Owners Equity?
1. Shareholders Equity/Owners Equity are things that a company’s owners own or have retained
2. Examples of shareholders equity include preferred stock, common stock, and retained earnings
How to read the balance sheet?
Once you understand what each column is, you need to go through the balance sheet row by row.
If you look at a balance sheet, the majority of the items are going to be either current assets or liabilities. What this means is that they are part of what a company owns or owes within one year (i.e., 12 months). If you want to get an idea about the financial health of a company, the balance sheet’s current assets do not tell you a lot. What you really need to look at is what is called non-current assets and liabilities.
These represent things that a company owns that can be converted to cash within one year (i.e., 12 months). There are two types of current assets:
This includes cash on hand, bank deposits, etc.
Inventory is usually a company’s raw material, goods, or products that have been purchased and are waiting to be sold
These are amounts that customers owe to a company for products and services. For example, if you order something from Amazon and choose the 1-day shipping option, then Amazon can record accounts receivable for the value of whatever was purchased – both because they will be paid within one year (i.e., 12 months) and they don’t really have to do any work until that date (they can use the money while it sits around).
These represent long-term investments that a company might own, but they can’t be converted to cash in one year (12 months).
Tangible assets are those assets that can be found in the physical world that a company owns, such as buildings, equipment, and equity in the form of stocks and bonds.
Intangible assets are those assets that do not exist physically and cannot be found in the physical world, such as patents, copyrights, goodwill, and brand equity.
Liabilities are divided into two:
Current liabilities are obligations that a company owes. They typically come in the form of invoices for paying back loans or things like employee wages, tax expenses, and utility bills. Examples include accounts payable, short-term loans, accrued salaries, and taxes due.
Long-term liabilities are typically five years or more. They usually come in the form of mortgages, bonds, and notes payable.
Examples include long-term loans for larger purchases such as homes and buildings. These loans cost less, but usually require more income to pay off the loan in the future.
Next, on the balance sheet, you’ll need to understand shareholders equity. Shareholders equity refers to a business’s total net worth, or its assets minus all of its liabilities. The initial sum of money an owner invests in the company is considered one form of shareholder equity and so are retained earnings, which refer to any profits that have been reinvested back into the company.
The Balance Sheet Equation
Assets = Liabilities + Shareholder’s Equity
When the equation is balanced, assets equal liabilities plus shareholder equity. As a result, shareholders’ equity equals assets minus liabilities. In other words, for every dollar of debt or obligations that a company has to others, there must be at least one dollar of assets exist somewhere in order for an investor to earn a return on investment.
Reasons for a Balance Sheet
Comparing your company’s balance sheet to those of other companies in the same industry will show you whether it is overspending or under-investing. In fact, the balance sheet tells investors exactly how much debt a company has in relation to its assets and shareholder’s equity. It will also show you how liquid the company is, i.e., what assets it has that can easily be converted to cash.
If a company is having trouble paying its current liabilities or long-term debts, this could translate into losing business, which in turn would result in lower sales and profits for investors of that company. The balance sheet, therefore, helps investors determine if a company is financially healthy or not.
Features and Clues of Balance Sheets
In terms of features, you can see that the balance sheets have some things in common. In particular, they always have columns with headings indicating what each category represents (e.g., assets). They also have rows with numbers indicating the specific value of that category (e.g., AU = 4,000). Finally, you will notice there is not a lot of space in between each row or column. The balance sheet always has two columns and three rows, with some exceptions like one row for example.
In terms of clues, remember that the balance sheet always has assets and liabilities. The liabilities are subtracted from the assets to find out what is known as shareholder’s equity, or what the company owes to shareholders. Shareholder’s Equity = Assets – Liabilities On a side note, you will also notice that asset values should be consistent with those of previous years (unless there has been a major event like a hurricane, fire, or even terrorist attack). If they are not the same as previous years, you must investigate why and talk to company officials to gain some insight.
With the understanding of the various components on a balance sheet, you can more easily compare your company’s performance to others in terms of financial health. Knowing what the balance sheet is and understanding its importance will allow you to use this tool for your own benefit as an investor by creating individualized investment strategies.
Finally, understanding how different companies’ balance sheets change over time will provide you with a wealth of information that will aid you in understanding future trends in financial markets.