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 SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. 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 recordsIncome Statement RecordsThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. all the income and expenditure of the business. Then we calculate net profit, which is then included in the Balance sheet under Retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company. (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 equivalentCash And Cash EquivalentCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. .”
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 AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. and Long Term Assets.
Below are few of the items which generally come under this head:
- Cash: It shows the cash balance of the company, be it the physical cash that they hold or the bank balance.
- Marketable Securities: Marketable SecuritiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company's balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it. include the short investments that the company has made. They can be in the form of bond investment or capital stock Capital Stock The capital stock is the total amount of share capital (including equity capital and preference capital) that has been issued by a company. It is a way of raising funds by the company to meet its various business goals.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 ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. are nothing but credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. 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 incomeAccrued IncomeAccrued Income is that part of the income which is earned but hasn't been received yet. This income is shown in the balance sheet as accounts receivables., 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 liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. and long term liabilitiesLong Term LiabilitiesLong Term Liabilities, also known as Non-Current Liabilities, refer to a Company’s financial obligations that are due for over a year (from its operating cycle or the Balance Sheet Date). .
It includes the following items:
- Accounts Payables: Accounts PayableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period. 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 creditTrade CreditThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front. 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 revenueUnearned RevenueUnearned revenue is the advance payment received by the firm for goods or services that have yet to be delivered. In other words, it comprises the amount received for the goods delivery that will take place at a future date. 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: CPLTDCPLTDCurrent Portion of Long-Term Debt (CPLTD) is payable within the next year from the date of the balance sheet, and are separated from the long-term debt as they are to be paid within next year using the company’s cash flows or by utilizing its current assets. includes all the debt payments which are accruing within a year.
Long Term Liabilities
- Long term debt: Long Term DebtLong Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability. 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 CapitalPaid-up CapitalPaid in Capital is the capital amount that a Company receives from investors in exchange for the stock sold in the primary market, including common or preferred stock. This considers the sale of stock that an issuer directly sells to the investor & not the sale of stock on the secondary market between investors. 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 dividendDividendDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company..
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 statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels., 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 assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity. It gives a better graphical representation of how our overall asset base looks like.
#2 – Horizontal Analysis Balance Sheet
In this horizontal analysisHorizontal AnalysisHorizontal analysis interprets the change in financial statements over two or more accounting periods based on the historical data. It denotes the percentage change in the same line item of the next accounting period compared to the value of the baseline accounting period., 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 sheetCommon Size Balance SheetThe term "common size balance sheet" refers to a percentage analysis of balance sheet items based on a common figure, with each item presented as an easy-to-compare percentage. For example, each asset is expressed as a percentage of total assets, and each liability is expressed as a percentage of total liabilities., which is more comprehensive and shows items both in absolute and percentage terms over a longer period.
This article has been a guide on how to Read a Balance Sheet. Here we learn how to understand and analyze a Balance Sheet step by step with the help of example and explanations. You may learn more about accounting from the following articles –