How to Read a Balance Sheet?

Reading and understanding the balance sheet of the company includes consideration of the accounting equation, which states that the sum of the total liabilities and the owner's capital is equal to the company's total assets, knowing different types of assets, shareholders' equity, and liabilities of the company and analyzing the balance sheet using ratios.

Balance Sheet is the most important financial statement as it helps us see the company's financial position at a given point in time. It is like a report card to measure a company's performance. The balance sheet, the Income Statement, and the Cash Flow statement are the three primary financial statements in accounting.

Knowing how to read a balance sheet is fundamental to financial literacy. It is divided into various sections. One of the most prominent ones is the assets section, which includes current assets like cash and equivalents, followed by long-term assets such as property and investments. Liabilities come next, divided into current liabilities (like debts and payables) and long-term liabilities (e.g., loans). The difference between assets and liabilities gives us the equity – the net worth of a business.

The Income statement records all the income and expenditures of the business. Then we calculate net profit, which is then included in the Balance sheet under Retained earnings (in case we do not provide any dividend) to shareholders. The cash flow statement tries to reconcile all the cash-based transactions, and the ending balance of this statement also goes into the balance sheet as “Cash and cash equivalent.”

The balance sheet reports the amount of a company’s

• Assets – Current Assets / Long-term assets
• Liabilities – Current Liabilities/Long-term liabilities
• Stockholders’ (or owner’s) equity – Common stock / Retained earnings

Remember the most important Balance Sheet equation –

Assets = Liabilities + Shareholders’ Equity

It has three main "heads," which are mentioned below, along with a brief description of what all items are covered in these heads:

It includes all the things that the company owns or anything that satisfies four attributes: future, probable, economic, and the benefit that will come under this head. It is further subdivided into Current Assets and Long Term Assets.

Current Assets

Below are a few of the items which generally come under this head:

• Cash: It shows the company's cash balance, be it the physical cash that they hold or the bank balance.
• Marketable Securities: Marketable Securities include the short investments that the company has made. They can be in bond investment or capital stock other companies. These investments can come in handy when we don't have sufficient capital because they have high liquidity and can easily convert into cash.
• Account Receivables: Accounts Receivables are nothing but credit sales that the company has made. It is an asset because the company has made the sale but is yet to receive the money.
• Inventory: Inventory is the stock of the company.
• Prepaid expenses and accrued income: Sometimes, the business needs to incur certain prepaid expenses before receiving any product. E.g., cash paid for advertisements. However, the benefit from it will accrue over some time. Similarly, we can have accrued income, which is income earned but not received. So we can recognize such income in the current fiscal year regardless of whether it is received or not. So it will be like accounts receivables, and we are assured of receiving our money in the future.

Long Term Assets

• Plant & Equipment: It shows all the machinery the company owns to make its products. We also charge depreciation on it to reduce its value over some time. Depreciation helps us show the true value of these assets in our business.
• Then we can have other assets like land, furniture, vehicles, computers, etc.

It includes the entire amount that the business owes to outsiders. Most businesses generally use leverage to increase their profit margin. Leverage is the use of debt to finance our business, thereby reducing the reliance on the owner's fund to fund the company's day-to-day operations. It is further sub-divided into current liabilities and long term liabilities.

Current Liabilities

It includes the following items:

• Accounts Payables: Accounts Payable is the total amount the company owes to its suppliers to supply the raw material or goods to the company. Most industries work on trade credit wherein they provide leeway to the buyer to make the payment, thereby giving him time to arrange the funds. It helps boost the sales of the business as they can make sales to those customers who don't have the money to pay upfront but will pay the money shortly.
• Unearned Revenue: Unearned revenue is just the opposite of Accrued income. In this case, we have received payment from our customers, but we have yet to deliver the goods. So it becomes a short-term liability until the delivery of goods.
• Current portion of long-term debt: CPLTD includes all the debt payments accruing within a year.

Long Term Liabilities

• Long term debt: Long Term Debt includes the amount we have raised for a longer duration and thus forms a critical part of our capital structure.

It includes the entire amount which the owner supplies to the business. In addition, it includes two main items:

• Paid-up Capital: Paid-up Capital includes the core capital of the business. In large businesses, it can be further segregated into common stock and preferred stock. In preferred stock, we tend to get preference over common stock in terms of dividend payment, but they do not have any voting rights, whereas common equity forms the base of the capital structure for the company.
• Retained Earnings: It provides a snapshot of the entire amount the owners have earned and reinvested in the business instead of taking the dividend.

The items mentioned above are not exhaustive, and more items can come under these three heads. The main purpose is to highlight the key items which can come under them.

Apart from that, there are two main formats to a balance sheet that we can use to demonstrate this financial statement, and they are mentioned below:

#1 - Vertical Analysis Balance Sheet

In this type of vertical analysis, we look at all the items in the balance sheet as a percentage of total assets. It gives a better graphical representation of our overall asset base.

#2 - Horizontal Analysis Balance Sheet

In this horizontal analysis, we look at all the items in the balance sheet in absolute numbers but over some time, and hence it is also known as trend analysis. The idea is to see how the company has progressed over a longer period.

Then we also have a common size balance sheet, which is more comprehensive and shows items in absolute and percentage terms over a longer period.

This article is a guide on how to Read a Balance Sheet. Here we learn how to understand and analyze a Balance Sheet step by step with the help of examples and explanations. You may learn more about accounting from the following articles –

• Balance Sheet Ratios
• What is the Off-Balance Sheet?
• Comparative Balance Sheet
• Trial Balance Format