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Grow Your Business Finances

How to Read a Balance Sheet

How to Read a Balance Sheet
Credit: Ingvar Bjork | Shutterstock

Organizations track revenue and expenses through a variety of forms, the most popular being the balance sheet. This document acts as a record of a company’s assets and liabilities, identifies money the organization has and what it expects to receive. Stockholders commonly use the balance sheet to determine a company’s worthiness of investment. This financial statement is an invaluable piece of information, but it can be quite difficult for the uninitiated to read.

Many investors view the income statement as the most important document, as it best indicates the amount of revenue generated by an organization. However, this amount doesn’t compare income against other financial factors that determine a company’s true value. So while the income statement provides a solid breakdown of income, the balance sheet is the true starting point for understanding a company’s financial position. It demonstrates how much a business owns (its assets), owes (liabilities) and the amount of equity left over for owners.

When reviewing a balance sheet, two of the most important elements to understand are a company’s liquidity and its solvency. Liquidity is a company’s ability to meet short-term obligations, such as how well it can pay off monthly debts without exceeding monthly income. Solvency is used to measure a company’s ability to sustain existing activities over a long-term period.

Assessing a company’s liquidity is dependent on what is called the current ratio, which is derived by comparing a company’s current assets to current liabilities. On the other hand, assessing a company’s solvency entails looking at the amount of debt relative to the equity the business currently has. Those amounts will vary largely, depending on the industry.

Assets are valuable resources controlled or owned by an organization. These include such resources as cash, accounts receivable, inventory, property, goodwill and intangible assets, such as patents. Each of these has a specific value associated to estimate the value of a company’s business dealings.

Liabilities constitute a company's obligations, which convey a message of future value. For example, accounts payable are unpaid balances, or unwritten promises to repay. Additional examples include notes payable and long-term debt. While some of these qualify as immediate expenses, they still qualify as a long-term investment that, once paid off, will equate into equity for an organization.

Balance sheets contain a section on owners’ equity, which quantifies an owner’s interest in a business. Typical shareholder equity includes all items, such as stocks — preferred and common — in addition to capital surplus and retained earnings. Equity is a residual sum calculated as assets minus liabilities. When the company’s assets exceed its obligations, the owner is deemed to have a positive financial interest.

Balance sheet templates can be downloaded from Microsoft's Office website. Credit: Microsoft.

When examining a balance sheet, assets may be broken up into tangible and intangible assets. If a company were forced to liquidate an asset, the amount they would receive is dependent on the type of asset. Tangible assets are physical in nature, such as cash, inventory, buildings and equipment. Intangible assets constitute non-physical items like patents and company trademarks. These assets hold a real value, though estimating that worth is rather difficult due to the amount of goodwill they entail.

If business becomes slow and assets must be sold, tangible assets are typically the first to be dipped into as they can be replaced. Intangibles are not so easily replaced and contribute more to a company’s overall value during an acquisition or merger.

The best way to read a balance sheet is by performing a common-size analysis, or by breaking down financials into percentages. Assets, liabilities and equity are quantified as percentages of total assets. Compare these percentages against previous values for the last three years to identify any changes. If a company’s property was 20 percent of total assets last year and became 25 percent of this year’s assets, this indicates new property was purchased.

Another method of analyzing balance sheets is to perform a horizontal common-size analysis. This entails calculating the year-over-year changes for each line item given on the balance sheet and income statement. This will indicate how an item has changed in value relative to the company’s other assets and revenue. Such an analysis will identify potential problems, such as continuing to build inventory despite increasing revenue.

Balance sheets can be as much an indicator of inefficiencies as well as revenue. For example, an investor may look closely at receivables to determine if they’re increasing faster than revenue. If so, this indicates an issue with collections that may be precursors to future organization-wide problems.

For small business owners who need to create a balance sheet, several software solutions are available. In fact, most of the accounting software reviewed by our sister site, Top Ten Reviews, has a tool for managing your balance sheet. Sage One, FreshBooks and Harvest get the highest rankings from TTR.

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