How to read a balance sheet
Reading or analyzing your balance sheet can sound a bit intimidating, like it’s something stock analysts and bank managers do. I would like to bring it much closer to you and help you become 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 get accurate financial statements for your business. It’s 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 looking after their books and that person had very basic knowledge of QuickBooks and knew how to enter invoices and pay invoices.
To prepare accurate financial statements for a business, a bit more accounting knowledge is needed. So let’s make sure we have that first.
reading a balance sheet
We can now begin to understand 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 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. Anything that matures within 12 months or the operating cycle is considered short-term.
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 comprised 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 capital section typically contains the following: common shares, 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 are looking at a single period, it analyzes it vertically, as opposed to comparative analysis when you are looking 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 balance sheet components and therefore 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 / Shareholders’ Equity