A balance sheet, also known as a statement of financial position, is one of the most important financial statements that you’ll encounter when doing your own personal or business accounting. However, it can also be one of the most confusing since it’s used to communicate information about both assets and liabilities. To make sure you’re reading yours properly, keep these five steps in mind when taking a look at your next balance sheet.
Step 1: Understand The Statement
A balance sheet is one of the three financial statements that companies use to give investors an idea of the company’s health. The other two are the income statement and the cash flow statement. A balance sheet shows a company’s assets, liabilities, and equity at a specific point in time. It’s important to read a balance sheet because it can give you insights into a company’s financial strength, solvency, and liquidity.
Companies list their assets from largest amount down to smallest on their balance sheets. The most common types of assets include cash, accounts receivable, inventory, and fixed assets. In some cases, companies will add non-current assets like goodwill or other intangible items. Companies also list their liabilities and owners’ equity on balance sheets in roughly reverse order of size. The most common liabilities are short-term debt and long-term debt. Short-term debts are typically due within one year while long-term debts may extend out past one year.
Step 2: Recognize The Income Statement, Cash Flow and Statement of Shareholders’ Equity
The balance sheet is basically a snapshot of a company’s financial position at a specific point in time. It lists all of the company’s assets and liabilities, as well as shareholders’ equity, which is the book value of the company. To read a balance sheet, you need to understand the three main financial statements: the income statement, cash flow statement and statement of shareholders’ equity. These three statements will give you a good idea of where the company stands financially.
The income statement is your company’s net earnings, or profit and loss, over a specific period of time. The cash flow statement tracks all sources and uses of cash in and out of your business. And finally, shareholders’ equity is essentially book value, showing what it would cost you to buy each share outstanding at market value. For example, if the shares are worth $100 and there are 100 shares issued, then the book value per share is $1.
The balance sheet also provides information about depreciation that shows how much of an asset has been used up by a company. A simple way to think about depreciation is that it reflects how much money has been spent on an asset that may no longer be useful today. Overall, reading a balance sheet requires some practice and patience, but it’s not too difficult once you get into the swing of things!
Step 3: Study the Financial Ratios Section
The financial ratios section of the balance sheet can be very helpful in telling you the story of the company’s financial health. In this section, you’ll find information on things like the company’s profitability, liquidity, and solvency. To get started, let’s take a look at some of the most important ratios:
- The current ratio measures a company’s ability to pay its short-term debts with its current assets. In other words, it shows how much liquid cash the company has on hand to cover its short-term obligations. A current ratio of 1.5 or higher is considered healthy.
- The quick ratio measures a company’s ability to pay its short-term debts with its quick assets.
- The debt-to-equity ratio is a measure of how much debt a company has compared to its owners’ equity.
In other words, it shows how much of its assets are financed by long-term debt instead of stockholders. A low number means that more of its capital came from equity investments than debt financing, and therefore greater control lies with stockholders. This can be an important indicator of financial health since debts must be repaid while equity investments are often written off as losses over time through depreciation and amortization.
Step 4: Compare with Other Companies
To get an idea of how well your company is doing, you can compare your balance sheet with those of other companies in your industry. This will give you a good idea of where you stand in terms of assets, liabilities, and equity. You can also use this information to benchmark your company against others and set goals for improvement. For example, if you find that the average number of days receivables on your balance sheet is 15 days but yours are at 25 days, then one goal might be to reduce them by 10 days over the next year.
In addition, comparing your balance sheet with those of other companies can help you identify problems and opportunities. It can give you insights into your company’s financial situation, as well as where there may be room for improvement. For example, if another company in your industry has lower debt levels than yours does, it might suggest that its business strategy is more successful or that it’s more financially stable. On the other hand, if it has higher debt levels but higher revenues than yours does, it might mean that they are using their funds better or taking on less risk than you are.
Step 5: Look for Trends
You can also get a good idea of the company’s financial health by looking at trends over time. This can be done by comparing the balance sheet from one year to the next. Look for positive or negative trends in things like cash on hand, accounts receivable, and inventory levels. This will give you a good idea of whether or not the company is improving or worsening financially.
You can use your year-to-year balance sheet comparisons to learn about how financial health and stability has changed over time. You may also want to compare it with other companies in its industry that are around the same size or larger (or smaller) in order to get an idea of whether or not it is in good shape financially. This will help you draw conclusions about how much of a risk you’re taking on by investing in its stocks. For more information, check out How Stocks Work and The Stock Market: An Overview.