In order to be able to make well-informed decisions and be financially stable, you must have information concerning your business' finances. However, analyzing the financial statement can be challenging, especially for those who are learning accounting and are unaware of numerous accounting terminology. There is one particular financial statement that any business owner should know how to analyze and that is the balance sheet.
Having information on how to read a balance sheet for beginners will help every single business owner learn about the assets owned by the company and its liabilities and equity.
Whether it is a small or growing company, knowing how to read a balance sheet will be useful when doing accounting.
What Is a Balance Sheet?
Balance sheets are a type of financial statement that shows the financial status of the organization on a particular date. The balance sheets include information regarding the company’s assets, liabilities, and shareholders’ equity.
Balance sheets are based on the accounting equation which can be expressed as follows:
Assets = Liabilities + Shareholders' Equity
Put simply, anything that the firm owns has been acquired using either loaned money or the owner's own money.
To give an example, if a firm has assets valued at $100,000 and liabilities amounting to $40,000, the firm's shareholders' equity will be $60,000.
Understanding the Three Main Components of a Balance Sheet
Prior to being taught how to read the numbers, one must first have knowledge about the three major parts of a balance sheet.
1. Assets: What You Own
Assets are considered economic resources that are owned or controlled by a business which can provide economic benefits in the future. Assets can be considered as the economic value that can be used in operating a business.
There are two kinds of assets:
Current Assets:
These are assets that will be turned into cash, sold, or used within one year or one operating cycle of a business.
These include:
- Cash and cash equivalents
- Accounts receivable
- Inventory
- Investments
- Prepaid expenses
Non-Current Assets
These are considered long-term economic resources that will be used for more than one year.
These include:
- Building and land
- Machines and equipment
- Motor vehicles
- Long-term investments
- Patents
2. Liabilities: What Your Business Owes
Liabilities can be defined as the financial obligations of a business firm that need to be paid to the creditors, suppliers, employees, and other parties.
The liabilities are classified into two main types:
Current Liabilities
It refers to the financial obligation which is normally due within one year or the operating cycle.
Some examples of current liabilities are:
- Accounts payable
- Short term loans
- Unpaid salaries
- Taxes payable
- Current portion of long term debts
Non-Current Liabilities
Non-current liabilities are obligations of the business that will be paid after a period exceeding one year.
Some examples of non-current liabilities are:
- Long term business loans
- Bonds payable
- Long term lease obligations
- Other long term financial obligations
3. Shareholders' Equity: What Remains for Owners
This account represents the net interest of the stockholders in the assets of the firm after subtracting all liabilities from assets.
It may be explained in simple terms as the amount that will remain after settling down the liabilities with the use of assets of the firm based on their accounting values.
Some commonly found components of this account are:
- Share Capital: It represents the total investment made by the stockholders in the firm.
- Retained Earnings: These represent the earnings generated but kept by the firm for its operations.
- Additional Paid-In Capital: This amount represents the excess investment made by the stockholders in the firm.
The existence of a positive equity account does not mean that the firm is in good financial condition.
How to Read a Balance Sheet Step by Step
Armed with knowledge of the three vital components, the interpretation of the balance sheet will be quite easy. Some of the activities that you ought to engage in while interpreting the balance sheet are as follows:
Step 1: Reporting Period
Look for the reporting date on the face of the balance sheet. A balance sheet is different from an income statement because the balance sheet does not cover a period but gives information about the date.
Step 2: Total Assets
Examine the total assets of the company. These include both current and non-current assets.
See if the company has enough cash and receivables to conduct its day-to-day operations.
Step 3: Study Total Liabilities
Study the liabilities of the company. Take note of rising liabilities, unpaid bills, and other liabilities.
Rising liability balance may need special consideration, especially if there is no rise in assets and cash flows.
Step 4: Learn about Shareholders' Equity
Determine the total equity of the company by subtracting its total liabilities from its total assets.
Learn about equity for various periods to check whether the financial position of the business is improving or deteriorating.
Step 5: Analysis of Assets, Liabilities, and Equity
Finally, check whether the balance sheet is in balance using the formula for accounting equation below:
Assets = Liabilities + Shareholders’ Equity
In case the above equation does not balance, it may mean that there are some mistakes in accounting records.
Important Financial Ratios to Understand
The ratios make it easy for one to analyze balance sheet data.
Below are three useful ratios that beginners should learn about:
- Current Ratio
Current Ratio = Current Assets ÷ Current Liabilities
It shows whether a business is having sufficient short-term assets to meet its short-term debts.
- Debt to Equity Ratio
Debt to Equity Ratio = Total Liabilities ÷ Shareholders' Equity
It enables one to evaluate the extent to which a business uses liabilities against owners' equity.
- Working Capital
Working Capital = Current Assets – Current Liabilities
It shows the short-term financial resources available to a business.
These ratios should always be analyzed in comparison with past periods and industry standards.
Common Mistakes Beginners Should Avoid
In learning how to analyze balance sheets, there are some mistakes that one can easily make and end up having incorrect financial conclusions.
Examples of some mistakes made are:
- Neglecting the liabilities:Focusing on the assets while ignoring the liabilities results in incomplete financial analysis.
- Thinking that a company is cash rich if profitable:Profitable companies may have cash problems.
- Neglecting accounts receivable: Not all the accounts receivable will be collected.
- Neglecting depreciation:The value of the fixed assets may decline.
- Failing to look at previous financial statements: Analysis should involve comparison of the balance sheets in different periods.
This will enable one to avoid making those mistakes.
How Professional Accounting Services Help Businesses
Achieving accuracy in maintaining balance sheets demands good bookkeeping skills and accurate transaction recording.
For small-scale businesses, keeping track of all such activities becomes difficult without expert help.
Professional accounting services are useful for companies to:
- Ensure that financial records remain accurate.
- Perform bank reconciliation and transaction reconciliation.
- Record their assets and liabilities.
- Create accurate financial statements.
- Detect discrepancies in accounting.
- Plan effectively using their financial data.
Expert accounting services will allow business owners to concentrate on growing their businesses rather than worrying about financial record-keeping.
Learning how to read a balance sheet for newbies is one of the key steps towards learning about finance and accounting. Through examining assets, liabilities and shareholders’ equity, owners of the business can see how good the financial position of their business is.
By regularly going through balance sheets and having knowledge of financial ratios, as well as keeping proper accounting records, you will be able to make the right financial decisions.
For more information and professional help, please contact The Fino Partners.
