If you don’t know how to read and analyze a balance sheet, read this:
A balance sheet is a snapshot of a business at a specific point in time. It serves two purposes.
Internally, it provides information about the financial health of a company.
Externally, it depicts the business’s resources and how they are financed.
The equation to remember is: ASSETS = LIABILITIES + EQUITY
• ASSETS
Assets are what a company owns.
Current assets are assets that a company expects to convert to cash within a year.
They include:
• Cash
• Investments
• Receivables
• Inventories
•Prepaid expenses
They help in determining short-term debt-paying ability.
Non-current assets are long-term investments that are unlikely to be converted into cash in the near future, such as:
Non-current assets include:
• Investments in stocks and bonds
• Lands or buildings
• Long-term notes receivable
Property, plant, and equipment
They are assets with relatively long useful lives that a company is currently using in operating the business.
This category includes:
• Land,
• Buildings,
• Machinery and equipment
• Delivery equipment and furniture.
Depreciation is the practice of allocating the cost of assets over a number of years.
The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life.
Intangible Assets
They are long-term assets that lack physical substance but are frequently very valuable.
Other intangible assets include:
• Goodwill
• Intellectual property
• Brands
• Trademarks
• LIABILITIES
Liabilities are what a company owes.
Current liabilities are obligations that the company must pay within the next year or cycle of operations.
They include:
• Accounts payable
• Wages payable
• Notes payable
• Interest payable
• Income taxes payable
The relationship between current assets and current liabilities helps evaluate the liquidity of a company.
When current assets are higher than current liabilities, the company is in a good position to pay its short-term creditors.
If not, the company can go bankrupt.
Long-term liabilities are obligations that a company expects to pay after one year.
Long-term liabilities include:
• Bonds payable
• Mortgages payable
• Long-term notes payable
• Lease liabilities
• Pension liabilities
• STOCKHOLDER’s (OWNERS’) EQUITY
This is the ownership claim on the company’s assets.
This section of the balance sheet consists of common stock and retained earnings.
If you add all the resources of a company and subtract its liabilities, what is left is the equity.
• HOW TO ANALYZE A BALANCE SHEET
We can analyze it using ratios.
Financial ratios are generally divided into four categories:
• Liquidity
• Solvency
• Efficiency
• Profitability
With the balance sheet, we will focus on the first three ratios
• Liquidity Ratios
Measure the short-term debt-paying ability of a company.
• Current Ratio =Current Assets / Current Liabilities
• Quick Ratio =Cash & Cash Equivalents + Accounts Receivables) / Current Liabilities
• Cash Ratio =Cash & Cash Equivalents / Current Liabilities
A ratio between 1-3 is a good sign for a company, suggesting that a business has enough cash to be able to pay its debts.
A ratio of less than 1 means that the company can’t pay its debts. It may be necessary to finance or extend the time required to pay creditors.
• Solvency Ratios
Measure a company’s long-term paying ability.
• Debt-To-Equity Ratio = Total Debt / Total Equity
• Debt Ratio = Total Debt / Total Assets
The higher the ratio, the more debt and risk the company has.
• Efficiency Ratios
Measure the efficiency of converting assets into cash.
• Receivables Turnover Ratio =Sales / Accounts Receivable
• Inventory Turnover Ratio =COGS / Inventories
• Asset Turnover Ratio =Sales / Total Assets
Efficiency ratios can also be measured in days.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
If you enjoyed this article, please comment, and share link with your near-ones.