How Do You Read a Balance Sheet?
A company’s balance sheet, also known as a “statement of financial position,” reveals the firm’s assets, liabilities, and owners’ equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company’s financial statements.
If you are a shareholder of a company or a potential investor, it is important to understand how the balance sheet is structured, how to read one, and the basics of how to analyze it.
- The balance sheet is a key financial statement that provides a snapshot of a company’s finances.
- The balance sheet is split into two columns, with each column balancing out the other to net to zero.
- The left side records a firm’s itemized assets, categorized as long-term vs. short-term.
- The right side contains a firm’s liabilities and shareholders’ equity, also separated as long-term vs. short-term.
- Equity is the remainder value when liabilities are subtracted from assets.
An Introduction To The Balance Sheet
How the Balance Sheet Works
The balance sheet is divided into two parts that, based on the following equation, must equal each other or balance each other out. The main formula behind a balance sheet is:
Assets = Liabilities + Shareholders’ Equity
This means that assets, or the means used to operate the company, are balanced by a company’s financial obligations, along with the equity investment brought into the company and its retained earnings.
Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners’ equity, referred to as shareholders’ equity, in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.
The balance sheet is broken into two main areas. Assets are on the top or left, and below them or to the right are the company’s liabilities and shareholders’ equity. A balance sheet is also always in balance, where the value of the assets equals the combined value of the liabilities and shareholders’ equity.
Within each section, the assets and liabilities sections of the balance sheet are organized by how current the account is. So for the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short- to long-term borrowings and other obligations.
It is important to note that a balance sheet is just a snapshot of the company’s financial position at a single point in time.
Types of Assets
Current (Short-Term) Assets
Current assets have a lifespan of one year or less, meaning they can be converted easily into cash. Such asset classes include cash and cash equivalents, accounts receivable, and inventory.
Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks. Cash equivalents are very safe assets that can be readily converted into cash; U.S. Treasuries are one such example.
Accounts receivables (AR) consist of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit; these obligations are held in the current assets account until they are paid off by the clients.
Lastly, inventory represents the company’s raw materials, work-in-progress goods, and finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large number of raw materials, while a retail firm carries none. The makeup of a retailer’s inventory typically consists of goods purchased from manufacturers and wholesalers.
Non-Current (Long-Term) Assets
Non-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year, and/or have a lifespan of more than a year. They can refer to tangible assets, such as machinery, computers, buildings, and land. Non-current assets also can be intangible assets, such as goodwill, patents, or copyrights. While these assets are not physical in nature, they are often the resources that can make or break a company—the value of a brand name, for instance, should not be underestimated.
Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.
Types of Liabilities
On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term.
Current (Short-Term) Liabilities
Current liabilities are the company’s liabilities that will come due, or must be paid, within one year. This includes both shorter-term borrowings, such as accounts payables (AP), which are the bills and obligations that a company owes over the next 12 months (e.g., payment for purchases made on credit to vendors).
The current portion of longer-term borrowing, such as the latest interest payment on a 10-year loan, is also recorded as a current liability.
Non-Current (Long-Term) Liabilities
Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet. For instance, a company may issue bonds that mature in several years’ time.
Shareholders’ equity is the initial amount of money invested in a business. If at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet and 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 side.
How to Read a Balance Sheet
Below is an example of a corporate balance sheet for Walmart from FY 2022:
As you can see from the balance sheet above, Walmart had a large cash position of $14.76 billion in 2022, and inventories valued at over $56.5 billion. This reflects the fact that Walmart is a big-box retailer with its many stores and online fulfillment centers stocked with thousands of items ready for sale. This is matched on the liabilities side by $55.2 billion in accounts payable, likely money owed to the vendors and suppliers of many of those goods.
Subtracting total liabilities from total assets, Walmart had a large positive shareholders’ equity value, over $83.2 billion.
Analyzing a Balance Sheet with Ratios
With a greater understanding of a balance sheet and how it is constructed, we can review some techniques used to analyze the information contained within a balance sheet. The main technique is financial ratio analysis.
Financial ratio analysis uses formulas to gain insight into a company and its operations. For a balance sheet, using financial ratios (like the debt-to-equity (D/E) ratio) can provide a good sense of the company’s financial condition, along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.
Looking at Walmart’s balance sheet above, we can see that the debt-to-equity ratio for 2022 was:
D/E = Total Liabilities / Total Shareholders’ Equity = $152,969 / 83,253 = 1.84.
The result means that WMT had $1.84 of debt for every dollar of equity value. Generally speaking, a D/E ratio under 2.0 is favorable.
Important ratios that use information from a balance sheet can be categorized as liquidity ratios, solvency ratios, financial strength ratios, and activity ratios. Liquidity and solvency ratios show how well a company can pay off its debts and obligations with existing assets. Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how the obligations are leveraged. These ratios can give investors an idea of how financially stable the company is and how the company finances itself. Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory, and payables). These ratios can provide insight into the company’s operational efficiency.
What Can You Tell From Looking at a Company’s Balance Sheet?
Balance sheets give an at-a-glance view of the assets and liabilities of the company and how they relate to one another. The balance sheet can help answer questions such as whether the company has a positive net worth, whether it has enough cash and short-term assets to cover its obligations, and whether the company is highly indebted relative to its peers. Fundamental analysis using financial ratios is also an important set of tools that draw their data directly from the balance sheet.
What Are the Main Things Found on a Balance Sheet?
The balance sheet includes information about a company’s assets and liabilities, and the shareholders’ equity that results. These things might include short-term assets, such as cash and accounts receivable, inventories, or long-term assets such as property, plant, and equipment (PP&E). Likewise, its liabilities may include short-term obligations such as accounts payable to vendors, or long-term liabilities such as bank loans or corporate bonds issued by the company.
Does a Balance Sheet Always Balance?
Yes, the balance sheet will always balance since the entry for shareholders’ equity will always be the remainder or difference between a company’s total assets and its total liabilities. If a company’s assets are worth more than its liabilities, the result is positive net equity. If liabilities are larger than total net assets, then shareholders’ equity will be negative.
The Bottom Line
A balance sheet, along with the income and cash flow statement, is an important tool for investors to gain insight into a company and its operations. It is a snapshot at a single point in time of the company’s accounts—covering its assets, liabilities, and shareholders’ equity. The purpose of a balance sheet is to give interested parties an idea of the company’s financial position, in addition to displaying what the company owns and owes. It is important that all investors know how to use, analyze and read a balance sheet. A balance sheet may give insight or reason to invest in a stock.