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Understanding How to Read a Balance Sheet of a Company

Posted on August 18, 2011 by Thomas DeGrace

Knowing how to read a balance sheet of a company and income statement is an important part of the process of evaluating which company to buy.  A balance sheet of a company is that financial statement which touches the three most important segments for a specific period of time. Reading and understanding a balance sheet is easy once you understand the basic elements.

What is a Balance Sheet?

So what exactly is a Balance Sheet? The balance sheets can give an investor a vivid idea of the company. These three segments are basically the assets of the company, its liabilities and the equity of the shareholders. All these are summarized and stated on a balance sheet. The basic formula that a balance sheet has to follow is that the assets should be a sum of the liabilities and the shareholder’s equity. Assets are those means through which the company operates its business transactions. And the assets are supported by the liabilities and the equities.

So why the summary sheet that follows this formula is called a balance sheet? Well, that is because whatever asset a company owns is paid for with the help of the liabilities and the equity of the shareholders. Now there are separate accounts for all the three segments that have been mentioned. Under the assets segment, the cash, inventory and the property of the company are mentioned. On the liability side of the balance sheet accounts of accounts that are to be paid or any long-term debts that the company is under. The balance sheets of different companies or business will vary accordingly.

There can be certain internal purpose which might compel a company to produce its balance sheet. It’s up to the management of the company to choose on which date and in what way would they like to produce the balance sheet. But a balance sheet to be prepared after the last day of a financial year stating the transactions of the company over that particular year.

Asset Types

There are two types of assets; one is called the currents assets and the other the non-current assets. The current assets are those which do not have a very long span. It might be a year or less. The current assets are easily converted to cash. The current assets are inclusive of cash and cash equivalents, inventory and accounts receivable. The safest of the current assets are the cash equivalents. The non-current assets, on the other hand, are difficult to turn into cash. They are inclusive of the tangible and intangible assets. By tangible assets, we mean computers, machinery, land and buildings. And intangible assets imply goodwill, patent or copyright. The potential of the non-tangible assets should never be undermined.

Type of Liabilities

The liabilities too are of two different types. The two types of liabilities are namely current and long-term liabilities. The current liabilities are to be cleared within a year’s time, whereas the long-term liabilities can be cleared after a period of one year. By shareholder’s equity, we mean the initial amount of money that has been invested in any particular business. If the total earnings of a company over a year’s time are reinvested in the company again, in the balance sheet that is shown in the account of the shareholder’s equity.

Reading a Balance Sheet

So how to read a balance sheet? The balance sheets are divided into two sections. The left-hand sides of the balance sheets have the accounts of the assets and the right-hand side summarizes the accounts of the liabilities and the shareholder’s equity. A balance sheet should have the value of the assets equaling to the combined value of the liabilities and the shareholder’s equity. The organization of a balance sheet is a very important aspect. The right-hand side of the balance sheet that is the liabilities and the shareholder’s equity section is organized taking into consideration how current is the account. The main way to understand and analyze a balance sheet is with the help of analyzing the financial ratio.

Benefits of Understanding a Balance Sheet

In what ways will you benefit if you can develop a better understanding of a balance sheet? It can help new investors a better understanding of about how a company’s financial position is at a particular time. To understand it even better you must study the balance sheet in combination with various other financial statements of the company. Also, you might compare it with the previous balance sheets to understand the progression of a company. While reading a balance sheet you must look at some factors. You should look at the shareholder’s fund and the net current assets. Bring into consideration the figure of the total current assets and the fixed assets of the company. Also, go through the accounting policies of the company.