Reading a balance sheet

A balance sheet (or statement of financial position) is an accounting report that provides a snapshot of a business’s position at a given point in time, including its assets, its liabilities and its total or net worth (assets less liabilities). “A balance sheet does not aim to depict ongoing company activities,” wrote Joseph Simini in Balance Sheet Basics for Nonfinancial Managers. “It is not a movie but a freeze-frame. Its purpose is to depict the dollar value of various components of a business at a moment in time.”

Balance sheets are typically presented in a vertical report form. Asset accounts are listed first, with the liability and owners’ equity accounts listed in sequential order directly below the assets. The term “balance sheet” originates from the the fact that the balance sheet is a representation of the accounting equation (assets=liabilities + capital), thus the two totals should balance.

Contents of a balance sheet

Most of the contents of a business’s balance sheet are classified under one of three categories: assets, liabilities, and (owners) equity.

Assets

Assets are items owned by the business, whether fully paid for or not. These items can range from cash to inventories, equipment, patents, and deposits held by other businesses. Assets are further categorized into current assets and non-current assets.

Current assets include cash, accounts receivable, inventories, prepaid expenses, and any other item that could be converted to cash in the normal course of business within one year.

Non-current assets include property,equipment (from office equipment to heavy operating machinery), vehicles, fixtures, and other assets that can reasonably be assumed to have a life expectancy of several years. In practice most non-current assets—excluding land—will lose value over time. This is reflected in accounts through a a process called depreciation. Non-current assets are reported net of depreciation in the balance sheet.

Non-current assets also include intangibles like the value of trademarks, copyrights, and a difficult category known as “goodwill.” When someone buys a company and pays more for it than the worth of its assets, the difference is written into the books of the acquired entity as “goodwill.”

Liabilities

Liabilities are the business’s obligations to other entities as a result of past transactions. Liabilities may be due to employees (salaries), investors ( for loans) or to other companies (who have supplied goods or services). Liabilities are typically divided into two categories:  current liabilities and non-current liabilities.

Current Liabilities are due to be paid within a year. These include payments to suppliers, payable taxes and accrued expenses (like wages and salaries). Current liabilities also include the “current” portion of long-term debt payable within the coming year. Non-current liabilities are amounts owed to lenders, mortgage holders, and other creditors payable over more than one year

Equity

Once a business has determined its assets and liabilities, it can then determine (owners’) equity i.e. the book value of the business. Owners’ equity, Or shareholders equity in the case of a limited company, is in essence the company’s net worth.

A balance sheet, if studied closely, can tell the any business owner much about the enterprise’s health. In Balance Sheet for Nonfinancial Managers, for instance, Simini points out that “in a well-run company current assets should be approximately double current liabilities.” He goes on: “By analyzing a succession of balance sheets and income statements, managers and owners can spot both problems and opportunities. Could the company make more profitable use of its assets? Does inventory turnover indicate the most efficient possible use of inventory in sales? How does the company’s administrative expense compare to that of its competition? For the experienced and well-informed reader, then, the balance sheet can be an immensely useful aid in an analysis of the company’s overall financial picture.”

(Some of the material in this post has been adapted from inc.com, the original post can be found here http://www.inc.com/guides/2010/06/how-to-read-a-balance-sheet.html)