How to read a balance sheet
Reading or analyzing your balance sheet can seem a bit intimidating, as if it is something that stock analysts and bank managers do. I would like to bring it much closer to you and help you become familiar with it so that you can use it as one of your business tools.
Preparation of accurate financial statements
To begin with, we have to obtain accurate financial statements for your business. It is not always as easy or obvious as it sounds. Many small business owners, when they first come to me, complain of not having a correct balance sheet. A family member was taking care of his books and that person had a basic understanding of QuickBooks and knew how to enter and pay bills.
To prepare accurate financial statements for a business, a little more accounting knowledge is needed. So, let’s make sure we have that first.
Read a balance sheet
Now we can start by understanding its main categories: assets, liabilities, and equity. Everything is really very logical and intuitive. Assets are simply things your business owns, liabilities are business debts and obligations, and equity is residual value. Your balance sheet should always balance and the equation is:
Assets = Liabilities + Equity
Assets and liabilities are in turn divided into short-term and long-term categories. Anything that expires within 12 months or the operating cycle is considered short term.
Examples of current (short-term) assets are: cash, marketable securities, accounts receivable, and inventory.
Long-term assets can be items such as: property, plant and equipment (land, buildings, equipment and vehicles) and intangible assets (for example, goodwill and trademarks).
On the liability side, we have the current category that is generally made up of: accounts payable, current portion of long-term debt, unearned income, taxes payable, and increased wages.
And here are examples of long-term liabilities: long-term notes payable and bonds payable.
The equity section generally contains the following: common stock, retained earnings, and net income for the period. The equity section will be different depending on the legal structure of the company.
Balance sheet analysis
If you are looking at just one period, you analyze it vertically, as opposed to comparative analysis when you are looking at two or more periods.
The best way to read and analyze a balance sheet is by using ratios, because absolute numbers do not tell the whole story and do not capture the important relationships between the different components of the balance sheet and therefore the business.
Ratios, on the other hand, are like barometers, helping you stay on the right track and warning you when things start to go in the wrong direction.
The most important ratios are:
Current ratio = Current assets / Current liabilities
Quick Ratio = Current Assets minus Inventory / Current Liabilities
Net Working Capital = Current Assets minus Current Liabilities
Debt / asset ratio = Total liabilities / Total assets
Debt / equity ratio = Total liabilities / Stockholders’ equity