How to read a balance sheet

As a manager you are not expected to be an accountant. But you need to understand financial statements. Here I will walk you through the balance sheet statement.

In another post I talked about how to read a profit and loss (income) statement. That document covers a length of time. Meaning it is how much you made over the last year or the last quarter.

The balance sheet is a little different. It is a snapshot of your business at any given time although usually it is prepared at the end of the year.

It is as if you went to the floor of your business and shouted “ok, ok, stop, I want to count everything we’ve got right at this point”.

I am going to explain this concept in a very simple manner. My purpose is to clarify. I don’t want anyone to get the impression that I am dumbing down or belittling the value of corporate accounting. All I want to do is provide a simple “lens” to make it easy to cut through the jargon and the maze of information.

If you still want to get the full blown story about balance sheets then please use a good professional text. In this article I am assuming your accountant has already created the balance sheet. I am here to show you how to understand it, not how to create it.

In a nutshell the balance sheet tells you how much you’ve got and how much you owe. That’s it.

That might sound too simple but that’s exactly my aim here. Keep it simple. Let’s use this lens to read a balance sheet.

The balance sheet will have a list or column titled “Assets” and another titled “Liabilities”.

Assets are what you own (or are owed by someone else) and liabilities are what you owe.

Everything that you own must equal everything that you owe. That’s why they are kept side by side and they total up to exactly the same amount at the bottom.

How can that be? How can everything you own equal everything you owe?

Don’t forget we are talking about your business so everything is counted from that perspective. It is basically what the business owns and what the business owes.

So if this is day one of the business and all that has happened so far is that you put in $10,000 into it which you deposited into the bank, then the business owns $10,000 which it has in the bank and it also owes $10,000 to you, the owner. The bank deposit is an asset and the capital is a liability.

See how simple it is?

Now let’s dig in a bit deeper.

Assets are all the items that the business owns (or it’s owed). They are broken up into two groups, current and fixed. Fixed just means everything that you own that will last more than a year. Current is everything up to a year. Fixed assets include things like buildings, plant and machinery. That makes sense, they last more than a year.

Current assets, are things that you own for less than a year such as product inventory waiting to be sold. It also includes the cash that you have in the till or in the bank. What if you keep the money for more than a year you ask?

Well normally you use cash to run the business. You would invest it in more than a year in something if you had the surplus and then that would be a fixed asset. You could for example put it in a long term deposit.

There is one more current asset. This is all the money the business is owed. This is usually the product of sales that have been completed but payment has not been received yet. It is money that the business is owed, it owns it. So to recap here are the typical assets again:

Fixed: Building, plan, machinery

Current: inventory, cash, debtors

Now let’s jump onto the other side, the liabilities, what the business owes. Current liabilities means anything up to a year. This one is easy, it is all the money you owe to the bank or anyone else and also to the shareholders who own the company. Your business probably has an account with the bank for short term (less than a year) financing. You also may be getting product like raw materials from your suppliers and have some time, say 90 days, to pay them back. These are all your current liabilities.

Don’t forget any net profit the business made is owed to the shareholders. That, and the money the shareholders put into the business are your liability under the equity section.

So to recap here is an example

Balance Sheet

Fixed Assets:

Buildings                              $1,000,000

Plant Machinery               $1,500,000

Total Fixed Assets                           $2,500,000

Current Assets:

Inventory                            $250,000

Debtors                                                $3,000,000

Total Current Assets                       $3,250,000

Total Assets                                       $5,750,000

 

Current Liabilities:

Creditors                             $2,000,000

Total Current Liabilities                                $2,000,000

 

Equity:

Shareholder Equity         $3,000,000

Profit                                     $750,000

Total Liabilities                                 $5,750,000

 

So you see how the total assets equals the total liabilities?

Hope you found this useful. Let me know what you think.

Thanks for reading.

 

Muneer

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