admin Posted on 2:47 pm

How to read a balance sheet

Reading or analyzing your balance sheet can sound a bit daunting, like it’s something stock analysts and bank managers do. I would like to bring it much closer to you and help you get familiar with it so that you can use it as one of your trading tools.

Preparation of accurate financial statements
To get started, we need to obtain accurate financial statements for your business. It is not always as easy or as obvious as it seems. Many small business owners, when they first come to me, complain about not having a correct balance sheet. They had a family member who took care of their books and that person had very basic knowledge of QuickBooks and knew how to enter bills and pay bills.

To prepare accurate financial statements for a business, a little more accounting knowledge is needed. So let’s make sure we have that first.

reading a balance sheet
Now we can start by understanding its main categories: assets, liabilities, and equity. It’s really all very logical and intuitive. Assets are simply things your business owns, liabilities are the business’s debts and obligations, and equity is the residual value. Your balance should always balance and the equation is:

Assets = Liabilities + Equity

Assets and liabilities are further divided into short-term and long-term categories. Short-term is considered everything that expires within 12 months or the operating cycle.

Examples of current (short-term) assets are: cash, marketable securities, accounts receivable, and inventory.

Long-term assets can be items such as: property, plant and equipment (land, buildings, equipment and vehicles) and intangible assets (for example, goodwill and trademarks).

On the liability side, we have the current category typically made up of: accounts payable, current portion of long-term debt, unearned income, taxes payable, and salary increases.

And here are examples of long-term liabilities: long-term notes and bonds payable.

The equity section typically contains the following: common stock, retained earnings, and net income for the period. The equity section will be different depending on the legal structure of the business.

balance sheet analysis
If you only look at one period, you analyze it vertically, unlike comparative analysis when you look at two or more periods.

The best way to read and analyze a balance sheet is to use ratios, because absolute numbers don’t tell the whole story and don’t capture the important relationships between the different components of the balance sheet and thus the business.

Ratios, on the other hand, are like barometers, helping you stay on track and warning you when things start to go in the wrong direction.

The most important proportions are:

Current ratio = Current assets / Current liabilities
Quick Ratio = Current Assets minus Inventory / Current Liabilities
Net Working Capital = Current Assets minus Current Liabilities
Debt to Asset Ratio = Total Liabilities / Total Assets
Debt to Equity Ratio = Total Liabilities / Stockholders’ Equity

Leave a Reply

Your email address will not be published. Required fields are marked *