Reading The Balance Sheet
Reading The Balance Sheet
By Reem Heakal
Contact Reem
March 10, 2004
|A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). It, together with |
|the income statement, makes up the cornerstone of any company's financial statements. If you are a shareholder of a company, it's important that you understand |
|how the balance sheet is structured and how to read it. |
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|How it Works |
|The balance sheet is divided into two parts that, based on the following equation, must equal each other: assets = liabilities + owners' equity. This means that|
|assets, or the means of production, are balanced by a company's financial obligations and the amount of money available to finance its operations. |
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|Assets are what a company uses for its production process, while liabilities are obligations to be paid to outside parties. Owners' equity, referred to as |
|shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and represents the |
|source of the business's funding. |
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|A balance sheet represents a specific period of time (usually one day) and is most commonly calculated on the last day of a company's fiscal year, Dec 31. |
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|Types of Assets |
|Current Assets |
|Three types of assets are included in the balance sheet: current assets, fixed assets and intangible assets. Current assets have a life span of one year or |
|less, meaning they can easily be converted into cash. Such assets are cash and cash equivalents, accounts receivable and inventory. All are short-term, highly |
|liquid assets that can easily be converted into cash and used as currency. |
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|Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks. Cash equivalents are stocks and other money market |
|instruments such as U.S. Treasuries that can be quickly changed into money. |
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|Accounts receivable are the short-term obligations owed to the company from clients. Accounts receivable for a company selling a good could expect to receive |
|monthly installments from its clients, while accounts receivable for a company offering a service could be in the form of monthly subscription fees. |
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|Finally, inventory represents the amount of materials currently available for production. If the firm is manufacturing a product, the inventory is divided into |
|three different stages: raw materials, work-in-progress (WIP) and finished goods. Inventory for businesses that sell retail will consist of products purchased |
|from the manufacturer and yet to be sold to the public. |
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|Long-Term Assets |
|Long-term assets, also known as fixed assets, have a life span of over one year. They can refer to tangible assets such as machinery, computers, buildings and |
|land. Depreciation is calculated and deducted from these types of assets. |
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|Long-term assets can also be intangible assets, such as a website domain, or a patent or copyright. While these assets are not physical in nature, they are |
|often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated. |
|Types of Liabilities |
|On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside clients. Like assets, they can be both|
|current and long-term. Long-term liabilities are debt that has more than a year's maturity. |
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|Current liabilities are typically paid within one year or less, and are therefore paid with current assets. Because current assets pay for current liabilities, |
|the ratio between the two is important: a company should have enough of the former to cover the latter. Current liabilities include such items as dividends |
|payable, accounts payable (what the company owes to suppliers for buying raw materials or retail products on credit), interest payments on long-term debt and |
|taxes payable. |
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|Owners' Equity |
|Owners' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings (after|
|taxes) into the company, the retained earnings will be restated from the income statement onto the balance sheet here. The sum of the two figures represents a |
|company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus owners' equity on the other.|
|Here's an example, demonstrating this balance between assets and liabilities plus net worth: |
|[pic] |
|Reading the Balance Sheet |
|When we look at the balance sheet we need to know how to assess the numbers. Financial ratios can be calculated from the balance sheet, and these help the |
|investor understand the state of liquidity and growth potential of the company in question. |
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|One example is the current ratio (current assets/current liabilities), which reveals a company's ability to pay its short-term obligations. In the above example|
|the ratio is 1.5, showing us that XYZ Company is not only liquid but also healthy enough to pay off its debts without taking out a loan. It also shows us that |
|the company is financing itself through a larger amount of reinvested earnings rather than through debt. When comparing companies in the same industry, the |
|investor can determine which company is the best investment. When compared against the industry's average, a lower ratio may indicate possible liquidity |
|problems. |
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|Another useful ratio is leverage (long-term debt/total net worth), which displays how assets are financed by the company, that is, whether by debt or retained |
|earnings. If a company has a high amount of leverage, or debt, it may be a sign that the company will have difficulty finding any future financing and is |
|therefore headed towards bankruptcy. |
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|Conclusion |
|When we look at a balance sheet from year to year, we can detect the growth potential and value of the company. It shows us how profits are used to finance the |
|company's operations, and if the company has enough cash for growth. Among other things, it also reveals if inventory levels are stagnant or active, if debt is |
|being paid and finally, what the cash value would be to shareholders in the case of bankruptcy, which is basically the value of current assets as they can |
|easily be converted into cash. |
By Reem Heakal
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