Before discussing how to read a balance sheet for dummies, let us first understand the concept, process & the purpose of accounting.

Accounting is one of the basic departments of a business organization. With the advent of new technologies like cloud accounting software like Quickbooks, 37% of all small businesses owners (in the US) believe that they won’t need accountants in 10 years’ time (As per a study).

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.

Related course: Financial Accounting Fundamentals (University of Virginia)

A typical accounting cycle starts with the recording of financial transactions in a 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 the final financial statements.

Journal > Ledgers > Trial Balance > Financial Statements

An accounting period of every business organization finally ends up with the preparation of financial statements. These statements mainly consist of a:

  • Cash flow statement
  • Profit & loss account (Also known as Income statement)
  • Balance sheet

A cash flow statement shows the cash inflow & outflow transactions of a business over a period of time. This statement is futher divided into operating, financing & investing activities. Following is a screenshot of a cash flow statement from one of my businesses:

how to read a balance sheet1

If the cash inflow is greater than the cash outflow it results in a positive cash balance. Whereas if the cash outflow is greater than the cash inflow it results in a negative cash balance or overdraft.

Related post: How To Improve Cash Flow of Your Small Business

A profit & loss account shows how a business generated revenue & how it incurred expenses over a given period of time. It’s prepared in horitzontal or vertical format. Following is a screenshot of a profit & loss account of one of my businesses:

how to read a balance sheet3

If the revenue (or income) is greater than the expenses, the business is profitable. Whereas if the expenses is greater than the revenue, the business incurs loss.

Related course: Introduction to Financial Accounting (Wharton University)

Now, let’s jump right into the topic & understand what a balance sheet is.

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 the value of each component of assets, liabilities, and equity as on a particular date, usually at the end of the accounting period.

Therefore, a balance sheet is also known as a summarised statement of assets, liabilities, and equity.

Balance sheets are generally prepared on the end date of a financial year. Example: 31st March, 2019 or 31st December, 2019.

The right side of a balance sheet consists of assets & the left side consists of liabilities & equity. Logically, the total of the left side (liabilities & equity) should match with the total of the right side(assets). I’ll explain this matching concept of a balance sheet later in this post.

how to read a balance sheet2

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

Assets are the resources controlled by a business which have monetary value and are expected to give future benefits to the business.

The assets of a business consist of:

=> Non-Current Assets (i.e. the long-term assets that are expected to give benefits for more than  period of 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.

=> 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 or account receivable or debtors,
  • Cash and cash equivalents,
  • Prepaid expenses,
  • Accrued income,
  • Current investments, etc.

Related course: Understanding Financial Statements & Company Position (University of Illinois)

Examples of Assets

Example 1:

John started a business by investing a cash of $ 10,000 & furniture of $ 1,000.  Here the total asset of John’s business on the first day (assuming no other transaction) will be $ 11,000 (cash + furniture). Cash will be under current assets & furniture will come under non-current asset.

Example 2:

Michael started a new business & sold goods worth $ 1,500 to one of his customers on credit on the first day. Here $ 1,500 will appear on the right side of the balance sheet(under current assets) as trade receivable or accounts receivable or debtors (assuming no other transaction).

Example 3:

Tony has been running a small business since past 10 years. He recently bought a trademark from another business by paying $ 5,000. This trademark will now appear on Tony’s balance sheet as a non-current asset.

Example 4:

Melissa started a new boutique business & bought inventory worth $ 15,000 on the first day. On that day, the inventory will appear on the balance sheet as a current asset.

Example 5:

Donald started a new business & paid $ 500 as advance to his employee on the first day. On that day, this advance will be shown under current assets of the balance sheet.

LIABILITIES

Liabilities are the present obligations of a business towards the outsiders which are expected to result in an outflow of cash or equivalent.

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 or account payables or creditors,
  • Outstanding expenses,
  • Income received in advance
  • Short-term borrowings, etc.

Examples of Liabilities

Example 1:

John started a business by borrowing a sum of $ 20,000 from a local bank. This loan will appear on John’s balance sheet under non-current or current liabilites (depending upon the terms of payment) on the first day (assuming no other transaction).

Example 2:

Michael started a business & bought goods worth $ 5,000 from his vendor on credit. This $ 5,000 will appear as trade or accounts payable under current liabilities on the first day (assuming no other transaction).

Example 3:

Tony paid salaries to his employees worth $ 5000 for the month of March, 2019 on 2nd April, 2019. In Tony’s business balance sheet (as on 31st March, 2019) this $ 5,000 will be shown as Outstanding salary under current liabilities (assuming there was no previous outstanding salaries pending).

EQUITY

Equity is the residual figure i.e. obtained by deducting total liabilities from the total assets. It’s also known as capital, net worth or owner’s equity.

The formula to calculate the equity of a business is

  • Equity = Total assets –Total liabilities

In other words, equity is the contributions made by the owner(s) of the business to the business.

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/stock capital (both common stock and preferred stock) and reserves and surplus (i.e. retained earnings).

Common stock is an ordinary kind of company’s shares that doesn’t guarantee dividend (profits of a company are distributed among shareholders as dividend). Dividend payout is subject to the amount of profit the company generates. From that angle common stockholders take risk as the real owners of a company.

On the other hand, preferred stock is an special kind of company’s shares that comes with a privelege of fixed & priority dividend. That means if a company decides to distribute dividend, preferred stockholders will get priority that too at a fixed rate.

Retained earning is a part of company’s profit that isn’t distributed as dividend but kept aside for future growth or business investments. Think of it like a part of shareholders’ equity that gets ploughed back into the company.

Examples of Equity

Example 1:

John started a business by investing cash of $ 10,000 & machinery of $ 3,000. In this case, the capital or equity of John’s business will be $ 13,000 (assuming no other transaction) on the first day.

Example 2:

Michael started a business by investing cash of $ 2,000 & purchasing goods costing $ 4,000 on credit. In this case, the equity of John’s business will be $ 2,000 (Asset $ 6,000 – Liabilities $ 4,000) on the first day (assuming no other transaction).

Example 3:

Tony closed his financial statement on 31st March, 2019 (the last day of financial year) with the following balance sheet figures:

ASSET
Cash = $ 1,000
Bank = $ 5,000
Furniture = $ 1,000
Accounts receivable = $ 3,000
Salary advance = $ 500

LIABILITIES & EQUITY
Equity = ??
Accounts payable = $ 2,000
Bank loan = $ 1,500

Equity, in this case, will be Assets ($ 1,000+$ 5,000 + $ 1,000+$ 3,000+ $ 500) – Liabilities ($ 2,000+$ 1,500) = $ 7,000

Example 4:

Melissa & her 3 friends run a company as equal common stockholders. Their company’s balance sheet as on 31st March, 2019 shows the following figures:

ASSET
Cash = $ 1,000
Bank = $ 5,000
Furniture = $ 1,000
Accounts receivable = $ 3,000
Salary advance = $ 500

LIABILITIES & EQUITY
Shareholders’ Equity
Common stock = ??
Preferred stock = $ 500
Retained earnings = $ 1,000
Accounts payable = $ 2,000
Bank loan = $ 1,500

Common stockholders’ equity, in this case, will be $ 5,500

Related course: How to Study A Balance Sheet (Udemy)

The Basic Balance Sheet Equation

The equation or formula of a balance sheet is:

Assets = Equity + 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.

  1. Equity and Liabilities  and
  2. Assets

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.

No matter how many transactions a business undergoes, the two sides of a balance sheet should always tally.

Here’re a few examples to demonstrate the matching concept of balance sheet:

Example 1:

John started a new business with the following assets, liabilities & equity (on the first day):

ASSET
Bank = $ 2,000, Inventory = $ 1,200  (Total = $ 3,200)

LIABILITIES & EQUITY
Owner’s Equity = $ 2,800  Accounts payable = $ 400 (Total = $ 3,200)

On the second day of his business, he sold goods to a customer costing $ 150 for $ 200. So, his inventory will reduce by $ 150, bank balance will increase by $ 500 & equity will increase by $ 50 (profit on sale).

Consequently, the new balance sheet at the end of the second day will be(assuming no other transaction):

ASSET
Bank = $ 2,200, Inventory = $ 1,050  (Total = $ 3,250)

LIABILITIES & EQUITY
Owner’s Equity = $ 2,850  Accounts payable = $ 400 (Total = $ 3,250)

Example 2:

Michael closed his financial statements on 31st March, 2019 with the following balance sheet figures:

ASSET
Land & building = $ 20,000 Cash = $ 2,000, Inventory = $ 1,200, Accounts receivable = $ 800, Salary Advance = $ 100 & Accrued Interest Income = $ 50   (Total = $ 24,150 )

LIABILITIES & EQUITY
Owner’s Equity = $ 17,250,  Accounts payable = $ 400, Bank loan = $ 5,000, Outstanding salary = $ 1,500 (Total = $ 24,150)

On 1st April, 2019, Michael entered with the following transactions:

  • Received a payment of $ 200 from a customer (Reduce accounts receivable by $ 200 & increase cash by $ 200)
  • Sold goods costing $ 1000 for $ 1500 to a cash customer (Reduce inventory by $ 1000, increase cash by $ 1500 & increase equity by $ 500)
  • Paid salary for the month of March, 2019 of $ 1,500 by adjusting salary advance of $ 100 & paying cash (Reduce salary advance by $ 100, reduce cash by $ 1400, reduce outstanding salary $ 1500)
  • Re-paid bank loan of $ 1000 in cash (Reduce bank loan by $ 1000 & reduce cash by $ 1000)

Consequently, the new balance sheet at the end of 1st April, 2019 will have the following figures:

ASSET
Land & building = $ 20,000 Cash = $ 1,300, Inventory = $ 200, Accounts receivable = $ 600 & Accrued Interest Income = $ 50   (Total = $ 22,150 )

LIABILITIES & EQUITY
Owner’s Equity = $ 17,750,  Accounts payable = $ 400 & Bank loan = $ 4,000 (Total = $ 22,150)

A Balance Sheet Sample/Format

Horizontal Format

balance sheet horizontal format sample

Vertical Format

balance sheet vertical format sample

A Balance Sheet Example

Balance sheet example

Related course: Basics of Corporate Finance (The University of Melbourne)

Importance/Purpose Of A Balance Sheet

Ownership & Liability Valuation

A balance sheet depicts the business’s assets and liabilities along with their respective values as at the end of an accounting period. Reading a balance sheet will help someone know how much asset a business owns and how much it owes to outsiders.

Investment Decisions

A balance sheet is an indicator of the financial strength of a business. 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.

Lending Decisions

The lenders such as banks and other financial institutions take lending decisions on the basis of the financial standing of the business.

If you were to apply for business loan, it’s almost certain that the prospective lender will ask you to submit the latest balance sheet.

Business Decisions

A balance sheet helps a business owner take crucial financial decisions like:

  • Seeking investment from outsiders
  • Taking borrowings from banks or financial institutions
  • Allowing credit to customers
  • Taking credit from vendors
  • Increasing/decreasing the working capital cycle
  • Profit margins

Avoiding Accounting Error & Fraud

Financial statements (which include balance sheets) help a business avoid accounting error & fraud. That’s because a proper accounting trail or system is a pre-requisite of a financial statement. You can’t prepare financial statements without recording each & every transaction of your business.

Using financial statements you can dig deeper into your business transactions & audit them. Each figure on a balance sheet will have a trail in your accounting system.

Selling A Business

Looking to sell your business?. Then your balance sheet can help the potential buyer to value your business & bid.

Business buyers generally look for a strong balance sheet with the following features:

  • Surplus cash
  • Low working capital cycle
  • Healthy bank balance
  • Acceptable leverage in the form of bank borrowings
  • Good financial ratios (will discuss about these later in this article)

Information to Government/Tax Authorities

Most governments or tax authorities require registered businesses to file financial statements once a year. This practice helps them to assess tax amount correctly, find tax evaders & ensure better tax compliance.

Customers

Industrial customers generally prefer to buy their requirements only from financially stable organizations. A balance sheet, therefore, can help you showcase your business’s financial strength & win industrial contracts.

Vendors or Trade Creditors

Vendors decide on trade terms like credit period, credit limit etc, based on a business’s financial strength. As such, a balance sheet can help them gauge the true status of business’s assets & liabilities.

How To Analyze A Balance Sheet

The correct analysis of balance sheet is a crucial task of the management and assists in diagonising 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.

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.

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.

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 important financial ratios based on balance sheet figures are:

Liquidity Ratios:

Current Ratio

If you’re looking to turnaround your failing business then this is the first ratio you should be improving.

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/Acid Test Ratio

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

Net Working Capital is nothing but the excess of current assets over current liabilities. It’s 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 a financial crisis. Loans are often tied to minimum working capital requirements.

Capital Structure or Leverage Ratios:

Equity Ratio/ Proprietary Ratio

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 Ratio

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.

Debt to Equity Ratio

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.

Related course: Understanding Financial Ratios & Their Implications (LinkedIn)

Efficiency Ratios:

Asset Turnover Ratio

Asset turnover ratio measures a business’s ability to generate revenue using its asset. In other words, it helps us to judge if a business is using its assets efficiently.

It’s calculated by dividing total revenue by total assets:

Asset turnover ratio = Total revenue / Total assets

Generally, the more the asset turnover, the better. A high asset turnover ratio means the business is using its assets judicially to generate high revenue figures.

Example: If the asset turnover ratio is 2.5, then it means that the business is generating $ 2.5 for every $ 1 invested in its asset.

Whereas a low asset turnover ratio means that the business is unable to generate adequate revenue in relation to the amount invested in its assets.

If you’re looking to raise funds for your startup, then this is one ratio you should be improving right away.

Working Capital Cycle

Working capital cycle is the amount of time a business’s funds are blocked in the net working capital. In other words, it measures how efficiently the business is able to convert it’s net working capital into cash.

The formula to calculate working capital cycle is as follows:

Working capital cycle = Inventory to sale conversion time + sale to collection conversion time – accounts payable to payment conversion time.

Where,

Inventory to sale conversion time is the time taken to convert inventory into sales.

Sale to collection conversion time is the time taken to convert a sale into cash.

And, Accounts payable to payment conversion time is the time taken to pay an accounts payable.

Example: John’s business shares the following figures with his accountant:

  • Average time it takes to sell inventory = 10 days
  • Average time taken for customers to pay for sale = 22 days
  • Average time taken for John to pay its creditors = 15 days

In this case, the working capital cycle will be = (10 days + 22 days) – 15 days =17 days.

The lesser the working capital cycle, the better it is. That means the business has blocked funds in working capital only for a few days.

On the other hand, if the working cycle is high it means the business is blocking its funds in working capital for a large number of days.

Rates of Return Ratios:

Return on Equity(RoE) Ratio

Return on equity ratio measures how a business utilizes its equity capital to generate profit.

The formula to calculate RoE is:

RoE = Profit/Equity capital.

Where,

Profit is the net profit before interest to lenders, dividend to common stockholders & after dividend to preferred stockholders.

And, equity capital is the equity capital the average equity capital invested across an accounting period.

The more the RoE, the better it is. Example: If a company’s RoE is 0.25 that means the company is able to churn a profit of $ 0.25 for every $ 1 invested as equity capital.

It’s for this reason that RoE is one of most important figures investors check before investing in a publicly traded company.

Return on Asset(RoA) Ratio

Return on Asset ratio measures how a business is using it’s assets to generate profit.

The formula to calculate RoA is:

RoA = Profit/Total assets

Where,

Profit is the net profit before interest to lenders, dividend to common stockholders & after dividend to preferred stockholders.

And, total assets as figured out in the balance sheet.

The more the RoA, the better because it means that the business is utilizing its assets properly to generate high profit for shareholders.

Return on Invested Capital(RoIC) Ratio

Return on invested capital ratio measures how efficiently a business is using it’s invested capital to generate profit. Invested capital is the sum of equity & debt capital.

It’s a very effective way to check how a business is using it’s funds raised from shareholders & lenders.

The formula for RoIC is:

RoIC = Profit/Equity+Debt

Where,

Profit is the net profit after tax & dividend.

The more the RoIC, the healthier the company is.

Conclusion

A balance sheet may look dreadful for a beginner. But, if you understand the concepts well, you can literally read any balance sheet within 10 minutes.

Related course: Foundations of Finance & Accounting (LinkedIn)

So, I have this post on how to read a balance sheet for dummies covered. Still have doubts? Please comment below.