Before discussing how to read a balance sheet for dummies, let us first understand the concept, structure & the purpose of a balance sheet.
Accounting is one of the basic departments of a business organization. With the advent of new technologies like cloud accounting software, 37% of all small businesses owners (in the US) believe that they won’t need accountants in 10 years’ time.
As such, it becomes important on the part of the business owners to understand the intricacies of financial accounting & reporting.
The purpose of accounting is to summarize the financial information & present them in a meaningful manner. Thus, accounting helps business owners to derive important financial figures like sales, gross profit, net profit etc.
A typical accounting cycle starts with the recording of financial transactions in Journal. After that, the journal transactions are posted to respective ledgers. From ledgers, the ledger balances are extracted & reported on trial balance. Now, the trial balance is further summarized & segregated to form final accounts.
An accounting period of every business organization finally ends up with the preparation of final accounts. These final accounts mainly consist of a Profit and Loss Account and a Balance Sheet.
Journal > Ledgers > Trial Balance > Final Accounts
The balance sheet is an important part of the final accounts or statements.
What Is A Balance Sheet
A balance sheet, also known as the position statement, reflects the financial position of a business i.e. the position of its assets, liabilities, and equity as on a particular date.
By “the position of assets, liabilities, and equity”, we mean what constitutes the assets, liabilities, and equity of a business and what is the value of each component of assets, liabilities, and equity as on a particular date, usually at the end of the accounting period.
A balance sheet is a summarised statement of assets, liabilities, and equity.
We are going to talk about each of these key balance sheet elements in the following paragraphs.
What Items Appear On A Balance Sheet
Assets are the resources controlled by an entity which have some monetary value and are expected to give future economic benefits to the entity.
The assets of a business consist of non-current assets (i.e. the assets that are expected to give economic benefits for a period of more than 12 months) such as
- Tangible fixed assets e.g. plant and machinery, furniture and fixtures, land and buildings, vehicles, etc.
- Intangible fixed assets such as goodwill, trademark, licenses, formulae, copyright, patent and other intellectual property rights, computer software, etc.
- Long-term investments (trade as well as non-trade)
- Long-term loans and advances, etc.
And, current assets (i.e. assets that are expected to be held for a period of not more than 12 months) such as
- Inventories of raw materials, work in progress and finished goods,
- Trade receivables,
- Cash and cash equivalents,
- Prepaid expenses,
- Accrued income,
- Current investments, etc.
Liabilities are the present obligations of an entity towards the outsiders which are reasonably expected to result in an outflow of economic resources.
Thus, they denote how much a business owes to its creditors and lenders. They consist of non-current liabilities (i.e. the liabilities which are to be repaid after a period of 12 months)such as
- Debentures, long-term borrowings from banks or other financial institutions, etc.
- Long-term provisions
And, current liabilities (i.e. the liabilities that are to be repaid within a period of 12 months) such as
- Trade payables,
- Outstanding expenses,
- Income received in advance
- Short-term borrowings, etc.
Equity is the residual figure i.e. obtained by deducting total outside liabilities from the total assets.
The net worth of a business is often determined in terms of its assets and liabilities.
The formula to calculate the net worth of a business is
- Net worth/Equity = Total assets –Total outside liabilities
Equity or simply Owner’s equity or capital is the contributions made by the owners of the business to the business, whether in cash or in kind.
Thus in case of a sole proprietorship business, it represents the sole proprietor’s funds invested in the business. In case of a partnership firm, it denotes the sum of individual capital contributions of all the partners. In case of a company form of business, it is represented as shareholders’ funds that comprises share capital (both equity share capital and preference share capital) and reserves and surplus (i.e. retained earnings).
The Basic Balance Sheet Equation
The equation or formula of a balance sheet is
Assets = Owners’ Equity + Outsiders’ liabilities
The equality between these two sides is an eternal truth in accounting because the assets of a business are the resources acquired by it with the help of the funds raised from equity and outside liabilities. Hence a balance sheet has two sides, viz.
- Equity and Liabilities and
The name “Balance Sheet” itself indicates that the total of all assets of an entity should, at any point in time, be equal to the total of equity and liabilities.
A Balance Sheet Sample/Format
A Balance Sheet Example
Importance/Purpose Of A Balance Sheet
- As mentioned earlier, a balance sheet depicts the business’s assets and liabilities along with their respective values as at the end of an accounting period. The users are able to know how much the business owns and how much it owes to outsiders.
- It is an indicator of the financial strength. The current, as well as prospective shareholders, take investment decisions on the basis of the financial position of the business as reflected in the balance sheet e.g. whether to acquire more shares, or to retain the existing shares, or to sell the shares, etc.
- The lenders such as banks and other financial institutions take lending decisions on the basis of the financial standing of the business.
- Various financial ratios can be derived from the assets and liabilities shown in the balance sheet. These ratios are significant tools in the hands of the management to analyze the financial strength of the business. Some examples of financial ratios based on balance sheet figures are:
- Current Ratio
- Quick Ratio/Acid Test Ratio
- Cash Ratio/Absolute Liquidity Ratio
- Net Working Capital
Capital Structure Ratios:
- Equity Ratio/ Proprietary Ratio
- Debt Ratio
- Debt to Equity Ratio
- Balances of assets and liabilities as shown in the balance sheet indicate the financial health of an organization. Hence the management can formulate appropriate strategies and take corrective steps to design the position as desired.
HOW TO READ A BALANCE SHEET FOR DUMMIES
How To Analyze A Balance Sheet
The correct analysis of balance sheet is a crucial task of the management and assists in diagnosing the problems that the business suffers from and to make informed decisions at right time in order to lead the business successfully.
The balance sheet provides necessary data from which you can derive various financial ratios and assess the liquidity position and long-term solvency of the business.
Today the investors are not just concerned with the earnings of a business but also its growth in the long run which is depicted on the balance sheet.
Establishing relationships amongst various balance sheet elements provides helpful information about the health of a business.
Let us discuss some of the important ratios.
- Current ratio is an important measure of liquidity (a firm’s ability to discharge its obligations as and when arises) of a business. It is analyzed to ascertain whether the business has adequate current assets to discharge the current liabilities as and when they fall due for payment.
It is computed as follows
Current Ratio = Current Assets / Current Liabilities
Usually, a current ratio of 2:1 is considered appropriate i.e. the business’s current assets should ideally be twice the current liabilities. If it is below the benchmark, it indicates that the liquidity position is not good.
Further, if the ratio falls below 1:1, this means that the current assets are not adequate to pay the current liabilities, and non-current assets may have to be realized to meet the short-term obligations or working capital requirements.
In order to gauge the weak liquidity position, the business may decide either to decrease the current liabilities or to increase the current assets.
- Quick ratio, also known as Acid-Test Ratio, is yet another measure of liquidity that measures the adequacy of quick assets (i.e. current assets other than inventories and prepaid expenses) to discharge current liabilities. Quick assets comprise cash and near cash assets.
Quick Ratio = Quick Assets / Current Liabilities
For example, if the total current assets of a business (including inventories of $ 4,000) are $50,000 and total current liabilities is $30,000, the Quick ratio is 1.5333
This indicates that the business has adequate near cash assets to pay its current liabilities and hence its liquidity position is good.
- Net Working Capital is calculated as
Net Working Capital = Current Assets – Current Liabilities
A positive Net Working Capital indicates that the business’s current assets are in excess of current liabilities and it has a good liquidity position. Bankers look at Net Working Capital to determine the company’s ability to weather the financial crisis. Loans are often tied to minimum working capital requirements.
- Debt Ratio measures the total debt used to finance the assets of the business. It relates the total outside liabilities to total assets.
Debt Ratio = Total Outside Liabilities / Total Assets
It measures the leverage position of the firm. A higher debt ratio indicates less risk for the equity holders. Thus a lower debt ratio is preferable in terms of risk.
- Equity Ratio compares the shareholders’ equity to total assets of the business. This ratio is sometimes referred to as Proprietary ratio.
Equity Ratio = Owner or Shareholders’ Equity / Total Assets
This ratio indicates what portion of the assets are financed through owners’ funds. A higher equity ratio is always desirable since it indicates that a smaller portion of the total assets is financed through debt and consequently reduces the leverage.
Thus the total of debt ratio and equity ratio is 1.
- Debt to equity ratio indicates how much debt a business uses in comparison to its owner’s equity.
Debt to Equity Ratio = Total Outside Liabilities / Owner or Shareholders’ Equity
Here outside liabilities may include both short term and long term liabilities or only long-term liabilities. Shareholders’ equity includes share capital and retained earnings excluding fictitious assets.
A debt-equity ratio of 2:1 is considered acceptable.
But a high ratio of debt to equity indicates that the business relies heavily on debt and is a debt trap. Thus the investors will be demotivated to acquire or hold their investments.
This is because there is a risk that all the earnings and cash flows of the business may be used to pay the interest and installments of borrowings and the shareholders or the owners may not get anything. Thus debt should be used up to a certain limit so as to build confidence amongst the shareholders.
So, we have this post on how to read a balance sheet for dummies covered. What are your thoughts? Please comment below.