Reading a Balance Sheet

Balance SheetThe Balance 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.read more is the most important financial statement as it helps us see the company’s financial position at a given point in time. It is like a report card to measure a company’s performance.

The balance sheet, the Income Statement, and the Cash Flow statement form 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.read more all the income and expenditures 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.read more (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. read more.”

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Steps to Read the Balance Sheet of a Company

The balance sheet reports the amount of a company’s

  • Assets – Current Assets / Long-term assetsLiabilities – Current Liabilities/Long-term liabilitiesStockholders’ (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 that satisfies four attributes: future, probable, economic, and the benefit that will come under this head. It is further subdivided 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.read more and Long Term Assets.

Below are a few of the items which generally come under this head:

  • Cash: It shows the company’s cash balance, 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.read more include the short investments that the company has made. They can be in 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.read more other companies. These investments can come in handy when we don’t have sufficient capital because they have high liquidity and can easily convert into cash.Account Receivables: Accounts ReceivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year.

  • read more 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. read more that 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 expensesPrepaid ExpensesPrepaid expenses refer to advance payments made by a firm whose benefits are acquired in the future. Payment for the goods is made in the current accounting period, but the delivery is received in the upcoming accounting period.read more before receiving any product. E.g., cash paid for advertisements. However, the benefit from it will accrue over some 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.read more, which is income earned but not received. So we can recognize such income in the current fiscal yearFiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more regardless of whether it is received or not. So it will be like accounts receivables, and we are assured of receiving our money in the future.

  • Plant & Equipment: It shows all the machinery the company owns to make its products. We also charge depreciation on it to reduce its value over some time. Depreciation Depreciation Depreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.

  • read more 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 inIt includes the entire amount which the business owes to outsiders. Most 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 company’s day-to-day operations. 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.read more 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). read more.

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.read more is the total amount the company owes to its suppliers to supply the raw material or goods to the company. Most 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.read more wherein they provide leeway to the buyer to make the payment, thereby giving him time to arrange the funds. It helps boost the sales of the business as they can make sales to those customers who don’t have the money to pay upfront but will pay the money shortly.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.read more 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.read more includes all the debt payments accruing within a year.

  • 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.read more includes the amount we have raised for a longer duration and thus forms a critical part of our capital structure.

How to Read Balance Sheet Equity?

It includes the entire amount which the owner supplies to the business. In addition, it includes two 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. read more 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 the owners have earned and reinvested in the business instead of taking the dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more.

The items mentioned above are not exhaustive, and more items can come under these three 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 two main formats to a balance sheet that 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.read more, 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 Equityread more. It gives a better graphical representation of our overall asset base.

#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.read more, we look at all the items in the balance sheet in absolute numbers but over some 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.read more, which is more comprehensive and shows items in absolute and percentage terms over a longer period.

This article is 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 examples and explanations. You may learn more about accounting from the following articles –

  • Balance Sheet RatiosWhat is the Off-Balance Sheet?Comparative Balance SheetTrial Balance Format