A strong balance sheet is the key to success in any business. Read on to get our 101 guide to understanding business financials: how to read a balance sheet.
You’re just getting started as a new investor in an up and coming company.
All of the sudden, someone asks you to look over the balance sheet to see if you have any questions. You don’t want to tell them that you don’t know how to read a balance sheet, so what can you do?
Luckily, learning about what balance sheets can do and how to understand them isn’t as difficult as it may seem.
Keep reading to find out more about why balance sheets are important for investors and others involved with a company.
What is a Balance Sheet?
The balance sheet is one of the more important parts of a company’s financial information. Using this sheet, a person can see what a specific company owns, what that company owes, and how much shareholders have invested.
For a company to survive, it has to be able to pay for the things that it owns. This much is clear, but sometimes, a company may not have all the cash upfront to make this happen. If this is the case, there are a couple of things that can happen.
The company can borrow money to pay for the things that it needs to own or it can take money from investors. By borrowing money, the company is taking on additional liabilities, and by taking money from investors, the company is issuing shareholders’ equity.
The revenue that a company generates is going to go back to the shareholders’ equity account or to their loan. In the long run, these revenues get balanced as assets, which can appear as:
- Marketable securities
- Prepaid expenses
- Accounts receivable
- Long-term investments
Why is a Balance Sheet Important?
Any balance sheet you come across will tell you exactly what is going on with a company’s finances at that current moment in time. This means that the balance sheet can and may often change for any given company.
You won’t be able to conclude anything that may be going on long-term with a business by looking at the balance sheet because the information won’t provide you with enough insight to look into the past. To do this, you would need to compare several balance sheets from that company against each other and view the differences.
Many companies may use their balance sheets to compare their finances with others in the industry they are in. This can help them get an idea of where their competition is and how they may be able to become better with their finances.
Any shareholder or someone interested in investing will need to know how to read the balance sheet to better understand the company.
How to Read a Balance Sheet
The first thing to know when reading the balance sheet is that it will be in two separate sections. The reason for the name balance sheet is that both of these sections have to be able to balance each other out.
There are different ways to set up the balance sheet, but you will find the two separate sections in some shape or form each time you look at one. Generally, the assets will be its own section and the liabilities and shareholders’ equity will be the other section.
Assets are always balanced by a company’s liabilities and shareholders’ equity. The assets help the business continue to function and run while the liabilities and shareholders’ equity make this possible.
Within each of these sections, there will be a more specific breakdown of where the money is and where it is going. Balance sheets have to be organized to make sense to the people that read them.
If something on either side ever changes, the other side will have to change to match. For instance, if the value of your company drops by $10,000 overnight and you no longer have that $10,000 on your assets side, you would need to do something to make it match on your liabilities side.
What Can You Do With a Balance Sheet?
Besides looking at the company’s current finances, there are a few other things to learn from reading and analyzing a balance sheet.
Some companies like to use their balance sheets to compare themselves with other companies in the field. They also use it for comparison with their past financial statuses. Companies are also able to identify trends with these balance sheets.
There are a number of ratios used to identify different information using balance sheets within a given company. For example, the return on equity ratio will give you information that you wouldn’t be able to see by viewing the balance sheet itself.
Using these different types of ratios and learning what they do gives you insight into a company’s financial condition.
Assets are the things that a company controls, even if they don’t technically own it. Liabilities are the debts to others that a company has to keep track of. These liabilities are usually kept in the same category as shareholders’ equity since they are both owed by the company.
The balance sheet works to help a company show that they are financially healthy. They can prove that they have balanced assets, or their assets are equal to the debts that they owe through liabilities and equity.
It is important to understand how to read a balance sheet because it gives you information about where the company stands. If you work for that company, want to invest in them, or are a shareholder, you may want to know how the company is doing to make better decisions for yourself.
Balance sheets can be a great tool to use when you want to find out about a financial situation within a company. Be sure to contact us if you want to get some more information on how understanding a balance sheet can be beneficial.