Financial statements are provided to allow people outside of the company to better understand the strength, profitability, and risk of the company. The balance sheet is one of the key reports used for financial analysis of any company.
The balance sheet provides a ‘snapshot’ in time of the company. What this means is the balance sheet provides the value of the business as of a certain date. Most of the time that would be December 31 of any year.
The balance sheet provides the organization’s assets, liabilities and equity. Let’s begin with the assets and work through the rest of the report.
Assets are a company’s resources. The assets are those things needed by the managers to run the day-to-day operations of the organization. The most common asset found on almost any balance sheet is cash. Cash is obviously needed by a company to pay it’s bills such as payroll and suppliers.
Other common assets include inventory, supplies, equipment, buildings, and receivables. The kind of assets found on the balance sheet really depend on the business. For example, a grocery store usually has inventory and buildings listed as the key assets among other things. A trucking company would have trucks as a the most predominant asset. A lawn service may not have any inventory but you would probably see plenty of equipment.
When analyzing the balance sheet, first consider if the assets make sense for the type of business. If the largest asset of a grocery store is receivables instead of inventory, that might would indicate you need to research deeper into the business to see what management is trying to do.
Next, consider the liabilities. Liabilities are obligations. The most common example of a liability is a loan. The loans are known as notes payable because the business must pay the note later. Other payables include accounts payable for supplies that have been received but have not been paid for yet.
Typically, a business also has salaries and wages payable. That is the amount the company owes the employees for work performed. Taxes payable is another type of payable for taxes that are due but have not yet been paid.
The more liabilities the business has the more obligation the managers have to make payments in the future. By looking at the amount of total liabilities you get an idea of the risk.
You can get a better understanding of the risky nature of the business by comparing the liabilities to the assets. In other words, how much of the assets are based on debt.
The current ratio is derived by taking the current assets divided by the current liabilities. Current assets are resources that will be available to the business within a year. Current liabilities are obligations that are due within a year. The lower the current ratio the lower the risk that the business won’t be able to make payments. Typically, it is good to see the current ratio above 1.
The Debt to Asset ratio takes total liabilities and divides total assets. This indicates how much the company owes in total to what the company has available. This is usually provided as a percentage. The lower the percentage the lower the debt the managers have to worry about.
Equity is the third piece of the balance sheet to discuss. Equity is the ownership piece of the business. Companies often offer stock to investors. If you purchase stock in the company, you are now an owner. Stockholders Equity is the amount of stock that was purchased from the company and then used by the company to buy the assets.
The other type of equity is created when a business keeps profit to help build-up the business. This equity is called Retained Earnings. You can think of it as retaining profit instead of giving the profit out to the owners. Over time the retained earnings generally grow when profits are regularly earned.
Some of the basic analysis tools to better understand the balance sheet are common sized balance sheet and trend analysis.
A common sized balance sheet puts every item on the balance sheet as a percentage of the total assets. This helps the analyst understand the most prominent items the business owns or owes.
Trend analysis looks at a series of years and considers how much each item has changed compared to the first or base year. This will highlight which items on the balance sheet have changed the most over recent years. This gives the analyst the ability to see if management is trending in the right direction.
The balance sheet offers the analyst a perspective of the potential of the business. The more resources available to the managers the more the managers have to work with. The balance sheet also offers a perspective on risk. Analysts can determine what the company owes and therefore will need to pay in the future.
The balance sheet is just one report though. Nobody can get a complete picture of the company with just that one report. That is why other financial statements, such as the income statement, will be covered in future articles.
However, with the balance sheet you are well on your way to building an understanding of the value, potential, and risk of the company!