A company’s financial statements allow its stakeholders to understand its operations better. In most cases, these will include the balance sheet, the income statement, the statement of cash flows, and the statement of retained earnings. Along with these financial statements, companies will also include notes to the financial statements. These notes include information about the company, its operations, and the other financial statements.
When understanding a company’s operations, these statements are significantly crucial. Each of these plays a role in providing information about a specific area. In most cases, stakeholders will prefer to understand the company’s financial performance. This performance comes from the income statement, including revenues, expenses and profits.
However, some stakeholders may also deem the other statements critical. Of the above four statements, only the balance sheet does not offer periodical information. Despite that, it is significantly crucial in presenting a picture of a company’s operations. Therefore, stakeholders must know how to read and analyze a company’s balance sheet. Before that, however, it is crucial to understand what it is.
What is the Balance Sheet?
The balance sheet is a financial statement that includes a list of balances. These balances classify under three categories, including assets, liabilities and equity. Similarly, it follows an accounting principle known as the accounting equation. Based on this equation, a company’s total assets will always equal the sum of its total liabilities and shareholders’ equity.
The balance sheet gets its name for two reasons. Firstly, it includes a list of several balances, which fall under assets, liabilities and equity. Therefore, the term balance sheet refers to how it consists of the sum of various account balances. In contrast, the balance sheet also has two sides. These sides consist of the total assets and total liabilities plus equity. The sum of both sides will be the same. Therefore, the term balance sheet also represents those balanced sides.
Another name used for the balance sheet is the statement of financial position. This name refers to how this statement shows a company’s current standing in assets, liabilities and equity. In essence, it presents its position at a specific date. As mentioned, it is not a periodical financial statement, unlike the others. Therefore, companies report the balances at a specific date using the balance sheet.
In essence, the balance sheet provides a snapshot of the company’s current standing in the three categories. It shows how much it owns and owes along the amount invested by its shareholders. Similarly, some may refer to it as the statement of net worth because it includes the company’s net assets. In most cases, it is the first financial statement that companies present in their annual reports.
Overall, the balance sheet is a fundamental financial statement that shows a company’s financial position. It includes a list of balances falling under the assets, liabilities and equity categories. As mentioned, it also follows a principle where the accounting equation is always true. The balance sheet also relates to the other financial statements in several ways.
How to read the Balance Sheet of a company?
Reading the balance sheet of a company does not require specialized knowledge. Instead, users must understand what the components of the balance sheet are. As mentioned, this financial statement has three categories, including assets, liabilities and equity. Each of these has specific accounts in it, which relate to that specific class. Therefore, it is crucial to understand these categories in detail.
Assets
Assets are resources owned or controlled by a company that will result in an inflow of economic benefits in the future. This balance sheet section usually includes a company’s assets, divided into current and non-current categories. From these, current assets include resources that the company expects to own or control for less than the upcoming 12 months. Anything above that falls under the non-current category.
For some stakeholders, assets are the most crucial part of the balance sheet. This section shows how much a company owns. Based on this value, users can estimate the future economic benefits that the company can generate. Similarly, this section also provides more detailed information about a company’s operations. For most companies, assets include cash and cash equivalents, inventories, accounts receivable, investments, fixed assets, etc.
Liabilities
Liabilities include obligations arising from past events that can result in outflows of economic benefits in the future. These obligations are essentially what a company owes to other parties that do not include its owners. Liabilities are the opposite of assets and essential to a company’s operations. These obligations represent a part of the finance companies use to fund operations in most cases.
Liabilities, like assets, fall under two categories, current and non-current. Usually, current liabilities include obligations that last for less than the next 12 months. Anything above that falls under the non-current category. Based on the classification, liabilities may consist of several items. For example, they consist of accrued expenses, short-term loans, loans, leases, bonds payable, provisions, deferred tax, etc.
Equity
Equity is the residual interest of shareholders in a company’s assets after deducting its liabilities. However, it only defines the term. In most circumstances, equity includes any balances that belong to a company’s shareholders. Usually, any funds generated by issuing shares or profits made by the company fall under this section. In essence, equity represents the shareholders’ claim to a company’s assets.
The term used to include this section in the balance sheet is shareholders’ equity. Unlike assets and liabilities, equity does not have several categories. However, it may divide balances into various reserves. For most companies, shareholders’ equity includes share capital, share premium and accumulated profits and losses. However, it may also consist of revaluation surplus, capital and revenue reserve accounts.
How to analyze the Balance Sheet of a company?
For most stakeholders, reading the balance sheet may be enough to comprehend the company’s position. However, some stakeholders may require more from the financial statement. These stakeholders will seek to analyze the balance sheet of a company. By doing so, they can get more information and the assets, liabilities, and equity of the company.
The analysis of a balance sheet occurs through financial ratios. These ratios compared the relative magnitude of one figure in the balance sheet compared to another. Similarly, these financial ratios may fall under several categories, for example, gearing ratios or liquidity ratios. Stakeholders can also use other metrics, although they also involve the income statement.
Three of the most prevalent financial ratios for the balance sheet include the following.
Current ratio
The current ratio is a relative measure of a company’s current assets to its current liabilities. This ratio shows whether the company has enough resources to pay off its short-term obligations when they arise. In most cases, companies will aim for a current ratio of above 1. The ideal magnitude, however, is around 2:1. The formula for the current ratio is as below.
Current ratio = Current assets / Current liabilities
Acid test ratio
The acid test ratio, also known as the quick ratio, is similar to the current ratio. However, it removes some resources that are not easy to liquidate instead of considering all current assets. It deducts inventories from the amount to calculate the ratio in most cases. By doing so, it looks at a company’s immediate liquidity. The formula for the acid test ratio is as follows.
Acid test ratio = (Current assets – Inventories) / Current liabilities
Debt to equity ratio
The debt-to-equity ratio measures a company’s total debt to its total equity. By doing so, it gauges the risk associated with its capital structure. Most creditors provide crucial information about how companies finance their activities. Most companies aim for this ratio to be low. However, several factors impact it. The formula for the debt-to-equity ratio is as below.
Debt-to-equity ratio = Total liabilities / Total shareholders’ equity
Conclusion
Companies prepare various financial statements, one of which includes the balance sheet. This statement involves several balances, which fall under three categories. Usually, uses can read the balance sheet by understanding what assets, liabilities and equity are. On the other hand, if they want to analyze it, they must use financial ratios.
