How to read a Balance Sheet

It’s like a Snapshot

It shows what they own (assets), what they owe (liabilities) and what other ‘owners’ own (shareholder capital) on a certain date of the year to give a solid picture of their financial position.

The basic formula for a Balance Sheet is:

What they own

This includes cash, what they have in their inventories, what customers owe them from past bill payments, also called Accounts Receivable.

What they owe

Bank debts (a.k.a. Bank Indebtness), and what the company owes to other vendors or suppliers, also called Accounts Payable.

Why do I care?

Think of it this way: we are a looking for the assets to be well balanced with the liabilities and shareholders’ equity.

If you think of it in terms of a household budget, the ‘assets’ of someone may be that they own a house and have it half paid off.

This means that a $300,000 house, has $150,000 of equity or the money that someone has paid in a mortgage towards it less the interest. These homeowners can now say that they have $150,000 in equity (or assets) along with whatever assets they have in cash, savings accounts or retirement accounts.

Then, their liabilities or what they owe to the banks or credit cards (their debts), coupled with what they owe family members (shareholders’ equity) has to be well balanced with what they own.

If they have $0 in savings, the house or in cash, but $100,000 in credit card debt, they aren’t in a good financial position, right?

It’s the same concept for a company and i t’s used to basically look into the future to make sure the business can survive. It is a snapshot of the business, so you can see if it has enough money, and used to assess how risky their financial position is.

For example, if they don’t have a lot of assets on hand and owe a lot of money, it’s not a good sign.

What is on a typical Balance Sheet?

ASSETS

• Cash
• Inventory
• Accounts Receivable

= TOTAL CURRENT ASSETS

• Equipment
• Furnishings
• Tooling, Molds
• Intellectual Property (Logos for example)

= TOTAL FIXED ASSETS

TOTAL CURRENT ASSETS + TOTAL FIXED ASSETS = TOTAL ASSETS

LIABILITIES

• Bank Line of Credit
• Accounts Payable
• Long Term Debts

= TOTAL LIABILITIES

SHAREHOLDERS’ EQUITY

• Share Capital (Basically what portion of their equity comes from shares they’ve issued)
• Retained Earnings

= TOTAL EQUITY

TOTAL LIABILITIES + TOTAL EQUITY = BALANCE SHEET AMOUNT (Negative or Positive)

What are some typical calculations that go behind the numbers on a Balance Sheet?

Since each number on the Balance Sheet line item above has a calculation or formula behind it, here’s what they are:

ACCOUNTS RECEIVABLE (A/R):
Open A/R Balance
+ New Sales
– Cash From Sales
= Closing A/R Balance

ACCOUNTS PAYABLE (A/P):
Open A/P Balance
+ Production goods received
+ Expense items
– Goods shipped
– Expenses Paid
= Closing A/P Balance

INVENTORY:
Open Inventory
+ Production goods received
– Goods shipped
= Closing Inventory

So how do I read this?

You typically look at the numbers, and use ratios to analyze the numbers based on comparable companies (think Apple, Blackberry and Palm), to see if a company’s inventory levels are too high versus the rest of the industry for example.

So back to our homeowner example. Based on what they owe in student loans and credit card debt, compared to other people their age, are they well off?

You’re probably going to say: It’s hard to say, since it’s personal finance and each person has a different situation…

But it’s the same for companies because it’s hard to say, because it depends on other things you have to compare such as market share, brand loyalty, and all of these other factors that play into whether or not you as an investor, can analyze whether they’re in a good position or not.

If a company has TOO much cash, you may not be too concerned about them.. but maybe you should be. Maybe in that industry, having too much cash means they’re not properly allocating their money to grow by putting more into advertising or research & development to keep up with their competitors.

But in other industries, having a good cash position could mean that they’re on top of the world.

These are all things you have to figure out for yourself.

What are some common ratios that are used?

• Debt-to-Equity Ratio (how much debt they owe compared to their assets. 4x as much debt? 1x?)
• Activity Ratios (looks at their current accounts to see how well they’re managing operations)
• Working Capital Ratios (Current Assets – Current Liabilities = Their Working Capital or Disposable Income)

And that’s about does it for the Balance Sheet.

RESOURCES

• FB: How to read an Income Statement (Another important document)
• Investopedia: Reading the Balance Sheet
• Investopedia: Reading Financial Ratios (All)
• MoneyChimp: Reading the Balance Sheet
• Fool.com: Reading the Balance Sheet & What it is