Learning to Read Balance Sheets | Article – HSBC VisionGo
Streamlining financial operations is one of the crucial aspects of running a successful business. In that context, managing financial statements like balance sheets becomes pivotal. We cannot stress enough the significance of learning to read a balance sheet accurately to ensure the financial status of your company.
While reading a balance sheet, you need to analyse the reported assets, equity, and liabilities of your company to have clarity on what your business possesses and its payables on a particular date. Although it may sound daunting at first, for balance sheet learning, you only need to grasp a few fundamental concepts, and you can read a balance sheet like a seasoned professional.
Meanwhile, if you are looking to propel the growth of your organisation by focusing on your core business areas, you are on the right track. You can do that better by leaving the accounting activities to our experts.
Here is all you need to know about the important aspects of a balance sheet.
Defining a Balance Sheet
A balance sheet is defined as a “statement that shows the financial status of a company.” In simple words, a balance sheet reflects the financial value of an organisation. A balance sheet shows the assets, liabilities, and the owners’ equity or net worth of a company on a specific date, which is also called the “reporting date”. The balance sheet helps to evaluate a business, along with two other major financial statements -- an income statement and the cash flow statement. To prepare and manage these financial statements, expert accounting services are required.
Generally, the frequency of preparing and distributing a balance sheet is monthly or quarterly, and reporting frequency is decided by an organisational policy or by law.
The Objective of Preparing a Balance Sheet
The main objective of preparing a balance sheet is to help business owners and investors clearly understand and measure the overall financial status of their business, besides their company’s assets and payables. This is why a balance sheet format includes assets on the left side and liabilities on the right.
The Work Process of a Balance Sheet
The name of this financial statement itself is self-explanatory, it balances the financial components. A balance sheet structure is split into two sides and makes sure the amounts on both sides are equal.
The main balance sheet formula is:
Assets = Liabilities + Shareholder Equity
Simply put, for the seamless operation of a business, it is important to achieve a balance between its assets and financial obligations/equity investment, along with the retained earnings.
Your company’s balance sheet provides a snapshot the financial position of your business at a certain point.
Key Terminologies You Should Know to Read a Balance Sheet
Let us understand the components in a balance sheet. Generally, the financial components of a balance sheet are split into 3 categories of value: assets, liabilities, and equity of shareholders.
Assets are tangible and intangible items with financial value that your company owns. Generally, assets fall into the categories of current assets and non-current assets and reflect positively in a balance sheet.
Typically, current assets have duration of around a year or less. Subsequently, the company converts them into cash. Major currents assets are:
- Cash and things equivalent to cash
- Accounts receivable
- Marketable securities
- Prepaid expenses
Now, non-current assets have a lifetime of more than a year and it is not easy to convert them into cash. These assets are long-term investments and comprise tangible and intangible assets, including:
- Equipment to manufacture products or carry out services
- Intellectual property
The right side of a balance sheet contains liabilities. It is like the opposite side of a coin, but with a negative value, because those are payables. While assets represent what your company owns, liabilities reflect what it owes to others.
Liabilities are financial obligations or payables of a business. If you owe money to debtors, they become part of liabilities or negatives in your balance sheet. Similar to assets, liabilities also fall into the categories of current or non-current liabilities.
Typically, current liabilities refer to expenses that are payable within a year. Some examples are below:
- Accounts payable
- Debt financing
- Payroll expenses
- Utility payments
- Rent payments
- Various accrued expenses
On the other hand, non-current liabilities are long-term payables, which include debts and various non-debt financial obligations that will not be outstanding or due within a year. Some examples are:
- Deferred tax liabilities
- Bonds payable
- Obligation to provide goods or services in the future
- Provisions for pensions
- Hire purchases
Note: Categorisation of Loans and Hire Purchase
A business splits some loans between current and non-current liabilities. When a loan is payable within a year, it falls under the category of current liabilities. The balance or hire purchase that is due beyond a year falls in the category of non-current liabilities.
3. Equity of Shareholders
Equity of shareholders, or owners’ equity, refers to the net worth of an organisation. It takes into account the initial amount of the owner’s investment in the business. If the business reinvests its net income at the year-end, those are considered retained earnings and will show under shareholders’ equity in the balance sheet.
Let us check a balance sheet example for better understanding. We assume that a company has the following assets and liabilities:
Cash — $2,500
Accounts receivable — $7,200
Inventory — $1100
Total assets — $10,800
Accounts payable — $160
Wages payable — $2,110
Total liabilities — $2,270
Common stock — $7,000
Retained earnings — $9,900
Drawing — −$9,770
Total equity — $7,130
Now, we will apply the formula:
$10,800 (Assets) = $2,270 (Liabilities) + $7,130 (Equity)
To Sum It All Up
The financial data that reflects in the balance sheet of a company is among the most important information for a business owner or potential investors to understand. Without a structured balance sheet containing all the assets and liabilities, it can be difficult to measure the true financial standing of a business. This is why reading a balance sheet accurately is a crucial skill for the stakeholders in a business.