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How to read a balance sheet

Knowing how to read a balance sheet is essential to making wise investment decisions, as well as knowing the financial stability of companies.

So what should a balance sheet tell you?
The balance sheet shows what a company owns and what it owes; if you use these two numbers, the difference shows you what the company is worth. A balance sheet is also known as a "statement of financial position", as it reveals a company's assets, liabilities and owners' equity (net worth). One thing to realize though is often this is not entirely accurate, as reality and what the paper says can have some discrepancies.

Why should you know how to read it?
Knowing how to read the balance sheet means having the ability to know how financially secure a company is. For example, if you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyze it and how to read it, so you know what your shares real value is, and where your company is heading.

How to read a balance sheet:
Generally a balance sheet is divided into two parts that, must equal (or balance out) each other. The main formula behind balance sheets is: assets = liabilities + shareholders' equity.

So you will see a section titled assets, and a section titles liability, and a section titled shareholders' equity. For the balance sheet to be accurate the amount of the shareholders' equity plus the liability must be the same as assets. If this is off something is not right.

So, to be able to read a balance sheet you need to understand the components assets, liabilities, and shareholders' equity. So let's take a closer look at each of these:

Assets are what a company uses to operate its business.
Liabilities and equity are two sources that support these assets.
Shareholders' equity is the amount of money initially invested into the company plus any retained earnings.
Liabilities are debts, salaries, etc. These are the things that require some of the money brought in.

To read a balance sheet correctly you need to know the types of assets and liabilities it represents.
The types of assets include current assets, and non-current assets, and depreciation taken on both.

  • Current Assets: By definition these are assets that have been around one year or less, meaning they can be converted easily into cash. This would mean things like actual cash being held by the company, accounts receivable, and any inventory the company current has. So, this means hard cash, or things equivalent to that, such as bonds, as well as any money owed by customers who purchased on credit, and the actual goods at the location.
  • Non-Current Assets: By definition these are the assets that are not turned into cash easily, expected to be turned into cash within a year and/or have a life-span of over a year. So these are things like the computers you have, your building you are in, maybe patents or copyrights, etc. Even something like a brand name that is not physically tangible, but has a huge impact on the revenue the company brings in is considered an asset.
  • Depreciation is taken into account with both current and non-current assets, it is calculated, usually by a standardized formula, and subtracted. Some balance sheets will have this separate, some include it with the asset numbers.

Liabilities that you see on a balance sheet are the financial obligations a company owes to outside parties. So, these can be short and long term debts, including accounts payables, and loans with interest.

Last but not least, shareholders' equity is the initial amount of money invested into a business. So, in other words, when you look at a balance sheet this is just one line with numbers.

If at the end of the year, a company decides to reinvest its net earnings into the company, these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder's equity account. This account 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 shareholders' equity on the other. Now you know how to read it, have at it!

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