How To Read A Balance Sheet Like An Expert

A balance sheet is very helpful to any investor since it gives one critical information about a company’s assets; both current and non-current ones, together with all its liabilities. It is also helpful given that it can enable you read the danger signs and healthy signs in assets. Finally, it helps a business know which assets are bringing more loss than gains so they can take appropriate action. Reading a balance sheet can be somehow confusing sometimes. According to business experts, it is the most misread of all financial records. This article is aimed at helping you be able, rather be in a better position to read your firms’ financial records better, so that you can and are able to take the right course of action and/or correct mistakes being made currently.

Balance Sheet

1. The structure

A balance sheet constitutes of the firm’s assets, liabilities and equity:

· Assets- these are things of value that the company owns or will be in possession of in the future (like land given to the company with a loan from the bank). Assets are usually objects that the company owns that can be valued in terms of money. They include substantial items such as cash, inventory, equipment and property owned, investments, money you are owed (accounts receivable), and prepaid expenses, patents and trademarks too.

· Liabilities- these are the things a company owes to others like; loans, taxes, credits, salaries, and many other things. They are basically items or services the company has to pay after a certain period of time. They are tabulated depending on their due dates and the time frame they are expected to be paid back. They are written on the right hand column.

· Equity- this is retained funds and earnings given to the company mostly by shareholders who are willing to take the risks and have hope for returns on their money. Equity may be from your own count as a sole proprietor, from the accounts of many different people in the case of partnerships or from shareholders in cases of public companies.

So basically what this means is that liability + equity= assets. This equation means that any sales growth brings about a larger assets base meaning more inventories, receivables and fixed assets.
The way in which a company’s assets are financed in terms of payables, debt and equity tells a lot about how healthy or unhealthy a company is. If it possesses a reasonable mix of equity and liability, it is a good company.

Balance Sheet

2. The format

A balance sheet is either represented horizontally or vertically.
That is the account and report formats respectively. This does not conform to the notion that it is a sheet with two sides that balance. It must however contain a list of:

- Current assets- assets the company currently owns. They include cash, short term investments etc. they are listed and totalled on the left hand side and then followed by fixed assets such as property and equipment.

In fixed assets, based on the estimated lifespan of equipment with depreciating value, the depreciated value may be subtracted from the fixed assets in the form of net depreciated property and equipment. The value of depreciation may be estimated from the many taxes paid.

- Non -current assets- assets the company will acquire in future like after one year or so. They include property, goodwill and intangibles. The calculated total amount of assets is keyed in at the bottom of this section.

- Current liabilities- debts the company has to pay like salaries. They are mostly payable within one year or less of the balance sheets date.

- Non- current liabilities debts the company will have to pay in future they are payable after more than a one year period.

- Shareholders’ equity- this is basically the amount of money given by shareholders.

It must basically follow the equation liability + equity= Assets. In a balance sheet, assets are named in order of how fast they can be turned into cash, consumed or sold.

Balance Sheet

3. Calculating the ratios

And here comes the whole essence of the balance sheet. It all melts down to the financial ratios. They will inform you if the company is losing more money than its making and if it is worth investing in; in cases where investors are trying to get their money invested in a firm. They tell you how capable a firm is in meeting its obligations.

As a balance sheet reading expert you will need to know how to write the ratios:

- Total margin- calculated by the formula total margin= net income/ total revenue, this tells you how much a company made per dollar. If the total margin is o.4 this tells you that for every dollar the company kept 40 cents.

- Return on total assets- calculated as ROA= net income/ total assets, it estimates how productive a firm was in using its assets. It states how many cents were made in one dollar made using the assets.

- Current ratio= current assets/ current liabilities- a higher current ratio, 1.0 and above, indicates a healthier company in terms of how it has been able to pay back its short term debts.

- Debt ratio= total liabilities/ total assets- it estimates how much of a firms financing comes from debts, in percentage. The lower the debt ratio the better. If a company needs a loan, a lower debt ratio will be best considered.

- Debt to equity ratio- it states how much of credit a firm has for each dollar of equity. A lower debt to equity ratio indicates, especially to creditors, a financially healthy company. It is calculated by the formula debt to equity ratio= total debt/ total equity.

- Total asset turnover- calculate how efficient a firm is in using its assets by telling the amount of revenue it generates per dollar of asset; the higher the ratio the better, although a balance is better since having too many assets cuts down on the profit margin.

It is calculated by; total asset turnover= operating revenue/ total assets.

As evidenced, it is clear that the balance sheet actually contains a great deal of helpful information and can therefore give you necessary tools to better understand how a company is performing in terms of its finances. However, you are urged to not only rely on a balance sheet when seeking to make informed investment decisions, but to rather go through everything including other critical parts of a company’s performance and financial statements. If things get complicated, you can be sure to contact your accountant for professional assistance.

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