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Guide to Understanding Balance Sheets

Arguably one of the most important statements, regardless from a business, investor or accountant’s perspective, the Statement of Financial Position (or balance sheet…) provides us with vital information regarding the health of a business. 

If you are planning to invest in stocks, knowing how to read the balance sheet is an essential skill to master before pouring your money into any company! 

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What is a Balance Sheet?

A financial document divulging the current book-value of the company, or in simpler terms, how much the company is currently worth. It does this by segmenting the company into three main categories: assets, liabilities, and owners’ equity (which will be explained later on). 

A balance sheet is usually prepared and distributed on a periodical basis, i.e. quarterly, yearly or monthly, depending on the company or governing authority’s policies. 

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Purpose of a Balance Sheet

It acts as a snapshot of the company’s financial position at any given point in time. Depending on the audience reviewing the statement, the balance sheet will offer different insights that are useful and relevant to the particular audience. 

When reviewed internally, the balance sheet provides insights to the health of the company – whether it’s performing or failing. Harnessing this information, the business leader can then decide on the appropriate course of action in order to bring the company to greater heights. 

When reviewed externally, interested parties can get a glimpse of the company’s resources and the method they were obtained (debt or equity). Based on this information, the potential investor can then make an informed decision as to whether they should buy into this company. Additionally, they might be able to extract information in a balance sheet to calculate key ratios such as liquidity and profitability. 

External auditors may use a balance sheet to ensure compliance of the company according to the regulations set by relevant authorities. 

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Components of Balance Sheet

The golden equation of a balance sheet is: 

Assets = Liabilities + Owners’ Equity

On the left hand of the equation we have the resources of the companies in the form of “assets”, and the right hand side shows whether these resources were funded by “liabilities” or “owners’ equity”. Following this logic, a balance sheet must always balance. Any inaccuracy can be due to errors or omitted information, and must be rectified before this statement can be published and distributed. 

1. Assets

Defined as any resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit, an asset must have inherent and quantifiable value. 

Current Assets

Includes anything that the company expects can be converted into cash within a year:

  • Cash and cash equivalents
  • Inventory
  • Prepaid expenses
  • Accounts receivable 

Noncurrent Assets

Includes long-term investments that are not expected to be converted to cash within a year:

  • Land 
  • Trademarks
  • Goodwill
  • Equipment and machinery 

2. Liabilities

A liability refers to anything that a company owes. They are defined as financial and legal obligations to pay an amount of money to a debtor. 

Current Liabilities

Includes any liability due within one year:

  • Accounts payable
  • Payroll expenses
  • Rent payments
  • Utility expenses 
  • Debt financing

Noncurrent Liabilities

Includes any long-term liabilities that are not due within one year:

  • Leases
  • Bonds payable
  • Bank loans

3. Owners’ Equity

Owners’ Equity, also known as shareholders’ equity, refers to the amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company’s debt was paid off in the case of liquidation. 

With a slightly different format from assets and liabilities, owners’ equity includes two main elements. 

Outstanding Shares

Refers to the amount of shares (or ownership) of the company given to external investors in exchange for a contribution to the business in terms of cash. 

Retained Earnings

Refers to the historical profits of a company. Any dividends given out to shareholders come from retained earnings, and should be subtracted off when distributed. Current or future profits will also flow into this account, and the opposite holds true for losses as well. 

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Yes, I know… that was a lot to digest… but if you’ve reached this part of the article, give yourself a pat on the back! It is widely known that financial statements can be a bore, regardless of whether you’re an accountant preparing the statement, a business leader analysing the statement, or even a student studying for your exams. But pull through, because these statements hold so so so much value, and are one of the most basic, yet important methods of understanding a company. 



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