The balance sheet is an indispensable tool for businesses of all sizes. At a glance, the balance sheet provides a snapshot of the company’s financial health. Arguably, the balance sheet is the most important of the three major financial statements, the other two being the income and cash flow statements. Learning how to read a balance sheet is the first essential step for any business owner.
Assets vs Liabilities
A balance sheet details what a business owns and compares it to what it owes. The difference between the two makes up the shareholder equity. Assets are listed on one side of the balance sheet, while the other side lists liabilities and shareholder equity. The sum of assets equals the sum of liabilities plus shareholder equity. This is because what the company owns, in other words assets, must always be equal to the total claims on those assets. Creditors, as well as shareholders, have a claim on assets. This basic equation allows you to assess at a glance how the shareholder funds invested in the business have grown or diminished.
By comparing assets to liabilities listed on the balance sheet, managers as well as outsiders, such as investors and suppliers, can assess whether the business will have a hard time paying its bills. Assets, such as cash, stocks, bonds, and and any liquid holdings that can easily be turned into cash, should ideally be higher than upcoming payment obligations. If the business has more upcoming liabilities than assets that can be turned into cash quickly, it might have a hard time paying its loans. Balance sheets typically separate payment obligations due in less than one year from longer-term debt to make this analysis easier.
The balance sheet also provides a detailed breakdown of the kinds of assets the business owns. The balance sheet of a furniture manufacturer, for example, will detail the amount of raw materials, such as wood and paint; the amount of work-in-progress, which is semi-finished furniture; and the amount of finished goods in the warehouse. This information helps to understand how much cash can be realized by selling the finished goods and how much time, effort and money must be invested to turn the raw materials and semi-finished goods into potentially cash-generating items. This helps the managers match resources and obligations.
The basic balance sheet equation, which stipulates that assets must equal liabilities plus shareholder equity, allows an analyst to play with numbers on either side to asses the potential impact of various possible outcomes on the business. For example, the impact of running a sale to liquidate inventory at only a slight profit can easily be evaluated if you know the basic workings of a balance sheet. In most cases, the analyst will obtain a more complete picture by also checking the income statement and cash flow statement. A basic course in accounting, covering the workings of all three financial statements, is therefore a must for anyone involved in business.