The balance sheet is one of the three main financial statements. This financial statement highlights the assets, liabilities and equity of a specific business at a point in time. Often referred to as a ‘medical report’ for a company, investors and managers can get good insight into how financially sound a company is by simply looking at its balance sheet.
Without question, this financial statement is complex. However, we’ve simplified the important information below and will help you navigate this financial statement.
How Does a Balance Sheet Work?
This financial statement is a sum of numerous journal entries during a specific time. It is often referred to as a “snapshot” of a company’s financial health.
During this time if the business acquires, or borrows, something that information will be recorded on the balance sheet. In short, this financial statement divides everything into three sections, which we’ll explore in greater detail below.
What Is the Main Purpose of a Balance Sheet?
Its main purpose is that it provides a summary of what the company owes and owns. In addition, this allows management and investors to get an understanding of the company’s assets, liabilities, and equity.
How Is the Balance Sheet Balanced?
Balance sheets balances due to double entry accounting. This means for every transaction, two accounts will receive a journal entry. Here are two examples:
- Say a business spends $5,000 in cash to purchase inventory
- The inventory account will increase by $5,000, but the cash account will decrease by $5,000
- Say a business secures $100,000 in debt from an investor
- The long term debt will increase, which is a liability, and the cash account will increase by $100,000 (which is an asset)
What Does a Strong Balance Sheet Look Like?
Believe it or not, you can’t simply look at the numbers and determine if a balance sheet is strong or not. You’ll need to do some ratio analysis to get a better understanding of its strength or weakness. Such ratios include:
- Current ratio. This ratio measures the liquidity of a business and if the business can pay off the current liabilities with current assets. The math is simple: Current assets / current liabilities = the ratio. Generally speaking, a ratio of 1-2 or more is considered good. However, that is subject to the business type and industry.
- Remember, cash is king. A business that has a lot of cash, or enough cash to pay off current liabilities, is a great metric to strive for.
- Debt ratio. Not only does debt put strain on households, debt can also cause a business to fail. Measuring how much debt a company has in proportion to its assets is what this ratio does. Simply divide the total debt by total assets. The higher the number, the weaker the balance sheet. Again, a healthy number is subject to the industry. Moreover, be sure to compare various competitors before making a decision if this figure is too high or healthy.
- Working capital. It is calculated by subtracting current liabilities from current assets. In short, working capital is the capital a business can use for daily operations. Strive for a ratio of 1.5 or greater.
There are an endless amount of ratios one can pull from the balance sheet, and each ratio tells a different story and serves its own unique purpose. The above 3 are simple, yet effective, ratios that can give a lot of insight into the health/strength of a balance sheet.
Does a Balance Sheet Show Profit?
Despite the great deal of important information the balance sheet shows, profit is not one of them. If you’re looking for the profit figure, you must reference the income statement.
Where to Find a Company’s Balance Sheet
Finding the balance sheet for a publicly traded company is easy. In fact, you can do so online. Simply visit www.finance.yahoo.com
Once there, enter the company’s ticker symbol in the search box. Navigate to the “Financials” tab and click on “Balance Sheet”.
What Are the Key Features of a Balance Sheet?
There are three key areas on a balance sheet. These areas include:
Assets is anything the company owes. For example, they can include:
- Prepaid expenses
- Accounts receivable
There are three types of assets:
- Current assets – which are assets that are expected to be sold within the next 12 months. Inventory is a great example of current assets.
- Fixed assets – these assets are for long-term use and will likely not be converted into cash within 12 months, such as buildings or machines.
- Intangible assets – a trademark is a common example of an intangible asset. You can’t touch or deposit a trademark, but without question a trademark has a value.
Liabilities are anything the business owes. For example, liabilities include:
Additionally, they can be broken down into two sections:
- Current liabilities – The liabilities that fall within the current category must be paid back within a year
- Long-term liabilities – These liabilities do not need to be repaid within a 12 month period
Also known as owners equity, shareholders equity represents what is left over after all debt has been paid. Moreover, shareholders equity is a rather simple formula: total assets – total liabilities = shareholders equity.
How To Read Balance Sheets
This financial statement can be read from top to bottom, although, a side to side comparison is also very common and helpful. Additionally, the balance sheet doesn’t necessarily tell a story the same way an income statement does or even statement of cash flows.
Looking at just the numbers is not enough. In short, these ratios must be layered into the balance sheet to make the numbers make sense and paint a full picture.
Advantages & Disadvantages of Balance Sheets
There are both advantages and disadvantages of this financial statement.
Advantages of Balance Sheets
- Balance sheets neatly organize a company’s assets, liabilities and equity.
- With proper ratio analysis, you can easily compare different companies on a leveled playing field.
- They are used by outside investors. This financial statement is often considered the ‘health report’ of the business. Moreover, if you’re an investor trying to get an understanding of the business, you may first start by reviewing the balance sheet.
Disadvantages of Balance Sheets
- The balance sheet ‘estimates’ the value of a long term asset. For example, this financial statement will put a valuation on a building the business owns. If the building isn’t well maintained, or if the commercial real estate market crashes, the value displayed on the balance sheet may be drastically off.
- The balance sheet represents assets, liabilities and shareholders equity at a singular point in time.
- The balance sheet doesn’t paint a picture of how long assets can last for. For instance, if you see a business has $5,000,000 in cash, you may think ‘that’s great!’ however, the business may be burning cash elsewhere in inefficiencies. Therefore meaning, that $5,000,000 is quickly depleted. The same can be true for the inventory holding position.
Balance Sheet: Profit, Loss, and Cash Flow Statement
The balance sheet is designed to show what the business owes and what the business owns. Whereas the profit and loss statement highlights the company’s income, expenses, and profit for a specific period of time. The cash flow statement shows how cash flows in and out of the business.
Balancing the Complexities
Without question, the balance sheet is an incredibly important financial statement. Like a medical report, a balance sheet can highlight the true health of a business. This is not only helpful for the internal management team, but also to any outside investor. With that said, despite how neatly and organized the information is displayed on the balance sheet, quite a bit of ratio analysis must be done before any hard conclusions are drawn.
If you don’t come from a finance or accounting background, these ratios may be foreign. If you’re looking to invest, and want to make sure you’re investing in a healthy company, the best thing you could do is work with a professional financial advisor. A good financial advisor will help you mitigate risk, and invest in various companies that are aligned with your risk and reward tolerance. Financial advisors simplify the complexity of the investing world!