How To Read a Balance Sheet
Amanda Souza
A balance sheet is one of the fundamental financial statements that provide a true and fair view of your business’s financial position at a particular point in time. It shows all the financial assets and liabilities of the business. Assets are what the business owns or has a right to, while liabilities show what the business owes to others.
Understanding the components and significance of a balance sheet is essential for assessing a company’s financial well-being. In this article, we’ll explore how to read a balance sheet.
Components of a Balance Sheet:
A balance Sheet is divided into three parts:
- Assets
- Liabilities and
- Shareholders’ Equity
Assets
Assets are resources that generate positive economic value and are owned by an entity. They are items acquired or created to enhance the company’s value. Assets can be categorised as current or noncurrent depending on their liquidity, i.e., how easily they can be converted into cash, sold, or used directly.
- Current assets: These are assets that can be converted into cash within a year. Examples include checking account balances, short-term investments, inventory, marketable securities, prepaid expenses, and cash, stocks, and bonds.
- Non-current assets: Also known as long-term assets, these are assets that may take longer to convert into cash. Typical examples include intellectual property (patents and trademarks), property, equipment and machinery, and land, buildings, and motor vehicles.
Liabilities:
Liabilities represent the amount owed by the entity to others. Any debt owed by a company to another party is considered a liability. Liabilities are displayed on the balance sheet according to their due dates, similar to assets. The duration of settlement determines whether a liability is current or non-current.
- Current liabilities: These are liabilities due within one year. Common examples include past-due wages owed to employees, due taxes, and amounts owed to suppliers for purchases made on credit.
- Noncurrent liabilities: Also known as long-term liabilities, these are liabilities with a due date more than a year away. Examples include borrowing not requiring repayment within a year, bonds issued by the company, deferred tax liabilities, and long-term lease obligations.
Shareholder’s Equity:
Shareholder’s Equity is the amount invested by the investors in your business entity. Thus,
Shareholder’s Equity = Paid-In Capital + Retained Earnings
This means that an increase in your business earnings would ultimately lead to an increase in shareholder’s equity.
Balance Sheet Equation:
The balance sheet adheres to the simple equation: Assets = Liabilities + Shareholders’ Equity. This formula ensures that the resources owned by the business are balanced against the claims of creditors and owners. Essentially, it reflects the net worth of the business.
Balance Sheet Format:
The Balance Sheet operates on the Accounting Equation, where assets on one side equal liabilities and Shareholder’s Equity on the other side. This equation signifies how your business funds its assets.
For everything your business owns (assets), funds are required. These assets can be funded by borrowing from creditors, taking loans from banks (liabilities), or acquiring funds from investors (shareholder’s equity).
For example, if your business takes a seven-year loan of €10,000 for plant and machinery, the cash account increases by €10,000 according to the double-entry system of accounting. Simultaneously, the Loan Account also increases by €10,000, ensuring balance on both sides of the Balance Sheet.
Assets, liabilities, and shareholder’s equity can be categorised into current assets, current liabilities, long-term assets, and long-term liabilities. The interpretation of these terms may vary based on the industry and type of business.
Importance of a Balance Sheet
Balance sheet analysis offers valuable insights into a company’s performance. Here are five reasons why balance sheets are important:
- Financial Health: Investors, creditors, banks and stakeholders rely on balance sheets to assess the financial health of an organisation.
- Growth Measurement: They serve as a tool to measure a company’s growth. By comparing balance sheets from different years, analysts can track the company’s progress over time.
- Loan Requirement: A balance sheet is a crucial document required to secure business loans from banks or investors.
- Performance Evaluation: Balance sheets allow stakeholders to evaluate an organisation’s performance and liquidity position, providing essential information for decision-making
- Planning and Budgeting: They facilitate the planning of expansion projects and the budgeting of unforeseen expenses. Additionally, balance sheets reveal how a company secures its funding, whether through profits or debt.
Contact us:
For more information on balance sheets and financial analysis, feel free to reach out to us at Gallagher Keane. Our experts are here to assist you in understanding and utilising financial data to make informed decisions for your business.
