Just like the income statement, the Balance Sheet is one of the most important financial statements used in business. Simply put, the balance sheet is a snapshot of a company’s financial position at a given moment. It offers a way to look inside your business and outline what it is really worth. But unlike the income statement, balance sheets are much less complicated and portray the overall picture of a company’s financial position.
Balance sheets include three categories: assets, liabilities, and owner’s equity (AKA stockholders’ equity). And it allows you to drill in a little more into those three things.
Assets – you can look at your current assets and long-term assets
Liabilities – just like assets, you can look at current and long-term liabilities
Equity – common stock and retained earnings
Remember when I said that it’s a lot less complicated? That was true, however, there are many pieces to it that you’ll need to remember. But they all fit into this pretty easy equation:
Assets = Liabilities + Equity or Assets – Liabilities = Equity
What this means is that your company’s assets are balanced by its financial obligations and the equity investment plus retained earnings.
Assets are what a company uses to operate its business. These are broken up into Current Assets and Long-term Assets (AKA Non-current Assets)
These are your assets that are expected to be consumed, sold, or converted into cash within the operating cycle, which is the average time it takes to convert an investment in inventory back into cash.
Assets are arranged by how liquid they are, which means the first thing on the balance sheet should be the current assets. Which also means your current assets are your liquid assets.
- Cash & Cash Equivalents – Cashis fairly simple. How much you have in the bank? Cash includes how much that’s required for a deposit used in lending agreements and business securities that have term of less than or equal to 90 days.
- Short Term Investments – These are bonds and capital stock investments owned by your business. These are not as liquid as money in your bank, but you could sell off your stocks if you need some dough.
- Inventories – this consists of what kind of merchandise you own. This is current and liquid because if you need it, you can sell off the inventory turning it into cash.
- Accounts Receivables – This is money that is owed to the company by the customers
- Other – This could include prepayments & accrued income, derivative assets, current income tax assets, assets held for sale, and other liquid assets.
Long Term Assets
These are more often than not physical assets that your company own and are used in the production process of the business. These will have a useful life greater than one year. They are not for sale to your customers. Long term assets can be classified into three main categories:
- Tangible Assets – this is the category that have a physical existence, such as real estate, buildings, offices, machinery, and furniture.
- Natural Resources – These have economic value pulled from the earth and used up over time. Most of us won’t have to worry about this because this includes oil fields and mines. So if you own an oil field or a mine you should just hire an accountant
- Intangible Assets – These are exactly how it sounds: intangible. This includes trademarks, copyrights, patents, franchise and goodwill. The cost of intangible
Liabilities are the financial obligations a company owes to outside parties. And just like with assets, they can be categorized as current and long-term liabilities.
These are probably future payments for your assets or payments of services that you must make. These obligations are expected to require the use of existing current assets or the creation of other current liabilities. That’s sort of confusing so an easy way to think about it is that current liabilities are those that will come due within one year.
- Accounts Payable – These are amounts you owe to suppliers for goods and services purchased on credit.
- Short Term Debt (AKA Notes Payable) – This is where you would take out loans to stock up inventory because so many people want your products (good job!).
- Current Maturities of Long-Term Debt – Any part of your long-term debt that has to be paid back within a year has to be reclassified from concurrent liability section to the current liability section.
- Unearned Revenues – This one is pretty self explanatory, but just in case, this is where customers pay for services or products before delivery.
- Other Accrued Liabilities – this includes money owed to employees as salary and bonuses that you haven’t paid yet.
Long Term Liabilities
These bad boys are obligations that are not expected to require the use of current assets or to create current liabilities within the year. Most of the time long term debt is subject to various covenants or restrictions. They can be obtained from many sources and may differ in the structure of interest and principal payments and the claims creditors have on the assets of your business.
- Known Long-Term Liabilities – These are the known obligations of your business, such as long term debt or unearned revenue.
- Estimated Long-Term Liabilities – These are the non current portion of employee benefits, warranties, deferred income taxes.
- Contingent Long-Term Liabilities – These are the non-current portion of debt related to litigation, debt guarantees, or environmental assessments.
Shareholder’s Equity is the residual interest for owners in the assets of the corporation. There are two primary sources: Paid-in Capital and Retained Earnings.
- Paid-In Capital are preferred stock and common stocks.
- Retained Earnings is the money that your company retains as part of its net profit to use to fund future projects, invest in new businesses, acquisition or take over of other companies or paying off debt.
What you Can Learn
Now that you know the categories that make up the balance sheet, it’s important to also know what you can learn from it. The ratios that come from the balance sheet are metrics that determine relationships between different aspects of your company’s financial position.
Debt to Equity Ratio (D/E) – Calculated by dividing your liabilities by your equity. This is used to evaluate your company’s financial leverage, and is important because it measures the degree to which your company is financing its operations through debt versus wholly owned funds. A high D/E ratio means that your business is highly leveraged and a risky investment.
Debt to Equity = Total Liabilities / Total Shareholders Equity
Return on Equity (ROE) – This is a measure of financial performance calculated by dividing net income by shareholders equity. ROE is considered a measure of how effectively you are using your company’s assets to create profits.
To calculate this, you will need to have the Net Income, which is pulled straight from your Income Statement.
ROE = Average Shareholders Equity/Net Income
Quick Ratio (QR) – The quick ratio is an indicator of a company’s short-term liquidity position and measures its ability to meat its short term obligations with its current assets. There are generally two different formulas to calculate:
QR = (Cash & Equivalents + Securities + Accounts Receivable)/Current Liabilities
QR = (Current Assets – Inventory – Prepaid Expenses)/Current Liabilities
A result of 1 is considered to be the normalquick ratio, since it means that your company is fully equipped to pay off current debts with its current liquid assets. If the ratio is less than 1, the company may be in a bit of trouble and may not be able to pay off it’s liabilities in the short term.
Current Ratio – The current ratio is a liquidity ratio that measures your company’s ability to pay short term debt within a year. It is simply a comparison of current assets to current liabilities.
Current Ratio = (Current Assets)/(Current Liabilities)
Typically, if your current ratio is less than 1, then it does not have the capital on hand to meet your short term obligations if they were all due at once. But this doesn’t really take into account aging accounts receivables and doesn’t give a complete representation of your company’s liquidity or solvency.
I hope you got a lot out of this post because understanding these numbers can really help you get a good grip on your business. Leave a comment and share. Let me know how you are going to implement a strategy to help and of course, let me know if you have questions!