How to Read a Balance Sheet: A Starter Guide for Businesses
In order to successfully run any kind of business you have to understand how to read a balance sheet. Think of a balance sheet as an instant overview of a company, regardless of its size or type. It doesn’t matter if it’s a small business or a multinational corporation — every business can be summarized by a balance sheet, usually as an annual report, to show financial health and market value.
You don’t need a degree in business to understand a balance sheet, either. In fact, a balance sheet can best be explained by looking at just three key categories: Assets, liabilities, and equity. In this article we’ll take a look at how to identify each of those items, as well as how to classify specific assets and liabilities in your own company.
The 3 Key Terms of a Balance Sheet
Let’s start with the basics: assets, liabilities, and equity. The balance sheet equation is this:
Equity = Assets – Liabilities
This is the formula that determines the health of a business.
Assets are anything of value the company owns. This can be actual money in the bank, investments, or tangible items like supplies or real estate. Some assets are easily identified and valued, like an office building or a piece of factory equipment. Others are a lot trickier to ascribe value to, like a trademarked marketing idea your firm owns.
Liabilities are anything a business owes money to or any ongoing financial obligation. Liabilities range from salaries owed to employees to rent on an office space to taxes to business loans owed to a bank or lender. If something costs you money either immediately or over time, it’s considered a liability.
When you subtract a company’s total liabilities from its total assets, the amount of money leftover creates the equity. That’s the net worth of the business. In a publicly traded company, the value of shareholder equity determines the health of the company on the stock market. In a privately held business, the owner’s equity helps determine how much he or she potentially sell a business for, or how much money they could borrow against that number.
Understanding Different Types of Short-Term Assets
There are a wide variety of types of short-term assets, also known as current assets, and a key to learning how to read a balance sheet is distinguishing among them. To determine if an asset is short-term, use one year as a rule of thumb.
Accounts receivable is any money owed to your company in the short-term. Specifically, accounts receivable is designated as any claim for payment in exchange for goods and services that is legally enforceable. If you send out an invoice for a service provided and ask for payment within 60 days, that’s accounts receivable.
If you’ve paid for something in advance for your business, that’s considered a prepaid expense, and thus an asset. As the amount of the payment expires, the value of this current asset reduces. For instance, if you pay for your company to have access to a software service for one year or pay a six-month insurance premium on a company vehicles, that’s a prepaid expense.
These are also known as short-term investments. Marketable securities include common stock and government bonds. Both can be easily converted into cash if necessary. Analysts place a heavy emphasis on marketable securities in a balance sheet because it helps determine a company’s current ratio of liquidity.
Along with marketable securities, cash equivalents are any low-risk securities a business could easily liquidate. Examples include a bank CD, U.S. government T-bills, or any kind of corporate commercial paper. Companies need to maintain a certain amount of cash equivalents so they can show an ability to quickly pay down debt.
Inventory is any item in a company’s possession that isn’t a long-term asset. So while the building a company owns isn’t a short-term asset, the product it makes that’s stored inside the building and sold to consumers is — especially if the product has a fixed market life.
Understanding Types of Long-Term Assets
Long-term assets, also known as non-current assets, are broken down into two major categories: intangible assets and tangible assets. The conference room table your company purchased is very much a tangible asset. The ideas you and your coworkers come up with at that table are intangible assets, but still have value.
Things like intellectual property can be considered an intangible asset, but there’s plenty of others: If you work in sales, a cultivated list of customers and potential leads for new customers is an intangible asset. Any particular training or certification your company has paid for its labor force to earn also falls under this category, as well as trademarks and patents.
Tangible long-term assets are easily identifiable — the building your company owns, the office furniture, vehicles, factory equipment, and anything tangible that doesn’t expire. Land your company owns is also a tangible asset, as well as any raw supplies or ingredients used to create a product.
Understanding Types of Liabilities
There are three major forms of liabilities you’ll need to understand if you want to learn how to read a balance sheet: current liabilities, non-current liabilities, and contingent liabilities.
Current liabilities, also known as short-term liabilities, follow the one-year rule as well. If the liability is a service, lease, or debt that’s owed within a year’s time, it falls under current liabilities. Current liabilities are assumed to be smaller debts that are easier to pay off if necessary.
Also known as long-term debts or long-term liabilities, non-current liabilities are usually found in bank loans and property leases. If you have a 10-year loan from a lender to start your business or sign a three-year lease on a building, these are considered non-current. It’s basically anything that would show up in more than one annual report.
Contingent liabilities are rare, but they do exist. If your company is facing a financial judgment in a lawsuit, a balance sheet might display a contingent liability based on the outcome of that case. Incorporating contingent liabilities into a balance sheet equation usually only occurs when a company feels that the cost of the contingent liability is likely.
How to Determine Equity, and What It Shows About Your Business
Once you know what you have, what it’s worth, and what you owe, you have the equity of your business. This number is the bottom line of your company.
Equity can be divided into two broad categories: Paid-up capital and retained earnings. Paid-up capital is the core capital of the business. This can be divided into common stock and preferred stock. Retained earnings is the dollar amount an owner has earned and re-invested in the business instead of accepting a stock dividend.
The term “working capital” refers to the immediate value of the balance sheet equation, and is calculated as the current assets minus the current liabilities. This number is used in the daily trading of a company’s stock. It helps establish a company’s financial position.
Once you have a clear picture of your company’s financial health, you can determine its debt-to-equity ratio, which is how a company’s financial leverage is determined. The debt-to-equity ratio is measured by the amount of total liabilities divided by the amount of shareholder equity in a company.
This number determines if a company is capable of financing itself through internal funding or debt to outside creditors. The debt-to-equity ratio also measures the ability of a company to cover its outstanding debts in the event of a business downturn or a recession.
You’ll also need a balance sheet to determine your company’s cash flow statement, which is another measure that outside investors use to determine a business’ health. A cash flow statement does exactly what it says — it monitors how cash goes into and out of a business. Specifically, a cash flow statement monitors how changes in the balance sheets for income affect cash and cash equivalents in the business.
The First Step to Growing a Business
Now that you’re able to identify the major categories of a balance sheet, you’re capable of understanding in large terms where money is coming into and out of your business, and how to display your business’ health to potential investors or purchasers. The clearer the picture of your net income is, the safer your business will be.
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