From this post we begin a series of posts covering the various aspects of a balance sheet. In this post we will begin with trying to understand how to read a balance sheet. So let’s begin….
Balance Sheet: How to read one
Balance sheet of a company states the financial position of a company as on a given date. Hence, it is also called as the Statement of Financial Position. It includes assets, liabilities and equity. The main thing people reading the balance sheet should know is that equation of a balance sheet is Assets = Liabilities +Equity.
All transactions recorded in an accounting period finally culminate in either an increase/decrease of an asset or increase/decrease of a liability/equity. The two sides of the balance sheet should be in balance at the end of year. Only then will the value of the resources obtained (assets) and the amount of capital raised to obtain those resources (liability (debt) and equity) tally.
Accrual accounting ensures that the balance sheet equation is always in balance, i.e. an increase in an asset either results in a decrease in another asset or an increase in a liability/equity. (Read here about accrual accounting and how it helps keep the balance sheet balanced).
Balance sheet components
Reading the balance sheet entails knowing its components and what they represent. Let’s take a look at them below;
Assets are resources gained from past transactions that are expected to provide economic benefits to the company over future accounting periods. Therefore they tell us about the future earnings capability.
Liabilities are obligations resulting out of past transactions are expected to cause outflow of economic benefits.
Equity is the owner’s residual interest in the assets after deducting liabilities. It describes what remains with the owner after paying off all the liabilities by converting all the assets into cash. It is also called as ‘net assets’, or shareholder’s equity or owner’s equity.
Balance Sheet format
Assessing liquidity and solvency of a company is often one of the main reasons for analysts for reading the balance sheet of a company. A firm is liquid if it can meet short term obligations and it is solvent if it can meet long term obligations.
GAAP and IFRS both require firm’s to group current and non-current assets and current and non-current liabilities separately and present them so on the balance sheet. This balance sheet format is known as classified balance sheet and is useful in assessing liquidity.
IFRS also allows firms to present a liquidity based balance sheet format. Under this balance sheet format, assets and liabilities are listed in order of liquidity.
Reading the balance sheet effectively requires the ability to tell between different classes of assets and liabilities. Let us take a look below at the different classes under which assets and liabilities are grouped.
Current assets and non-current assets
Current assets are all those assets which are expected to be converted into cash or used up within one year or one operating cycle, whichever is greater. One operating cycle is the time from purchasing the inventories to receiving cash from the sale of the finished goods. Current assets are usually presented in the order of liquidity starting with cash as it is most liquid. They represent the operating activities of the firm.
Non-current assets are those that will not be converted into cash or used up within one year or one operating cycle. They present the strategic and long term investments of the firm whose benefits will accrue over multiple periods and tell us about the investing activities of the firm.
Current and non current liabilities
Current liabilities are all those financial obligations that are expected to be settled within one year or one operating cycle, whichever is greater. Current liabilities are all liabilities which meet the following criteria;
- Settlement is expected during the normal operating cycle
- Settlement is expected within one year
- Held primarily for trading purposes
- The firm does not have the unconditional right to defer settlement for more than one year.
The excess of current assets over current liabilities is called working capital. The size of the working capital tells us how liquid the firm is and its ability to meet short term obligations as they become due. Working capital should however not be too large as it would mean more resources that can be productively used elsewhere are tied up in excess assets. For example funds tied up in excess inventories. The inventory balance maintained by a firm should be of an optimal size just enough to keep the operating cycle functioning smoothly.
Non-current liabilities are those that do not meet the criteria for current liabilities. They provide information of a firm’s long term financing activities.
With this we come to an end of this post….embedded below is a ppt summarizing the post for your reference…
in the next two posts we will examine the various types of current assets and liabilities and non current assets and liabilities recorded on the balance sheet in detail….tune in again then…u can also stay updated by subscribing to the blog…just use the SUBSCRIPTION options on the page…:-)
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
This post contains affiliate links. Please see the disclosure policy for more information.