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How to Read a Balance Sheet

You might know this, he balance sheet is the financial statement that details what an organization owns, its assets, and what it owes, its liabilities, all as of a particular point in time typically the end of the quarter or year.

Information about financial fitness

The balance sheet is particularly important because it provides clues about an organization’s financial stability, it’s risk and it’s liquidity, its ability to meet at shorter and longer term financial obligations. We all know what can happen when organizations are no longer able to pay their debts this is why most public companies must prepare and disclose balance sheets.

To the extent that assets on the balance sheet exceed liabilities, the difference represents shareholders equity a positive figure to the extent the opposite is true where the liabilities is exceed assets you have a shareholder deficit.  The balance sheet is also the financial statement that provides a window on the likelihood that an organization may become insolvent.

The standard on preparing a balance sheet

Organizations typically provide balance sheet figures as of the end of the most recent reporting period, usually end of the calendar quarter or fiscal year along with balances from the end of the prior fiscal. Assets are listed first and then about halfway down liabilities, followed by stockholders equity.

By definition assets must equal the sum of liabilities and shareholders equity.  This relatively simple formula is sometimes called the basic accounting equation. A note here: the assets and liabilities themselves are segregated into two distinct buckets, current and non-current.

Cash is king

On the assets on the balance sheet assets are ordered from the most liquid assets of the organization owns to the least liquid starting with current assets. Thus, on just about every balance sheet you will see the first asset to appear under current assets will be cash and cash equivalents.

Cash is self-explanatory as for cash equivalents these are essentially any risk-free securities with a maturity of less than 90 days.  Examples might include money market accounts a three month certificate of deposit for a bank or United States treasury bill, all very liquid in cash like investments.

The other assets that typically make up current assets include marketable securities any stocks bonds or other liquid investments the organization might own. We can look at the sum of the cash cash equivalents and marketable securities balances to get a sense of the real liquidity in an organization might have.

Accounts receivable

Accounts receivable which we mentioned earlier amounts owed the company by its customers typically follow marketable securities on the balance sheet.  There are very few firms perhaps not all that collect all amounts they are owed from their customers therefore organizations must make an estimate as to how much of the total receivables they are owed will not be collected.

Readers of financial statements have to pay very close attention to such estimates to ensure we are comfortable with them. Take a close look at the estimate for the allowance for doubtful accounts for all periods that are reported. Accounts Receivable are a wonderful thing but only if you collect them.

We need to pay very close attention to the accounts receivable balance, changes in the balances over the years presented and then the allowance for doubtful accounts the company has recorded as a reserve against those receivables.

Other assets

The most common word you will find in financial statements is, indeed, the word “other”, usually appearing several times in the balance sheet alone, just because there are usually other current assets: other long-term assets, other current liabilities and other long-term liabilities.

What you want to do is to make sure these other accounts, the unidentified growing objects, are not material and growing excessively. Also we would also want to make sure that the company is not placing assets on their balance sheets that might have no business being there.

The principal issues with respect to any organizations fixed assets are threefold: 1) what constitutes something that should be considered a fixed asset? 2) how are organizations fixed assets valued on the balance sheet, and 3) how much on average the organization is spending each year on fixed assets.

Intangible assets

Every organization has them, although they may or may not appear on the balance sheet. Unlike fixed assets which are clearly tangible, we can see and touch them, intangible assets do not had any physical characteristics.
Intangible assets include things like goodwill brand names trademarks and copyrights and patents and most balance sheets have one or more intangible assets.

Generally speaking, organizations only report the intangible assets on their balance sheets that they have acquired from another firm usually is a part of mergers or acquisitions activity. But, the balance sheet generally does not reflect each and every asset a company owns, and missing intangibles are one example.

The liabilities

By definition this is the amount the organization expects to pay within the next 12 months. What we need to do is relatively simple. To compare the amount of cash and current assets the organization has the amount of current liabilities it owes. So, basically, we are looking for is that current assets exceed current liabilities a quick test we can do to assess an organizations liquidity.

While we know that any long-term debt has a maturity date beyond 12 months we cannot tell exactly when it is due,  therefore when considering long-term debt it is imperative that review the footnote in the financial statement that deals with long-term debt.

Some debt a company might have is not listed on the balance sheet at all. This is known as off-balance-sheet debt and the most common example is operating leases a typical agreement between the landlord and the tenant.

Reading a balance sheet

The key takeaways about the balance sheet reading are:

  1. the balance sheet provides crucial information about an organization’s liquidity and risk as of a particular point in time.

  2. the balance sheet is not a statement of market value organizational net worth because many assets and organization owns and certain liabilities it owes are not reflected at all on the balance sheet. In addition most assets are not valued at their current market values.
  3. the balance sheet like all financial statements contains many estimates we need to be sensitive to potential impact of these estimates on reported results.
  4. as we glance down the balance sheet we must investigate any significant changes in account balances from one year to the next, especially in certain accounts like cash Accounts Receivable and  long-term debt.