How do you read the balance sheet of a company?

A Balance Sheet is one of the financial reports that is provided to the

stakeholders of a business to help them quantify the financial strength of a

company. Note: The Balance Sheet is a snap-shot of the financial status of a

company at a particular point in time. Here is what a typical Balance Sheet

looks like:

At its most basic level, the Balance Sheet describes the things of value that
the Company owns/controls (Assets) while identifying the people who

have claims over those assets. i.e. the external funding entities
(Liabilities) and the internal investors (Owners equity). The Balance Sheet

gets its name from the fact that the the total value of the Liabilities and the
Owners Equity will always equal (be in balance with) the total value of the

Assets. i.e. using the example above ...

Assets 1,275,000 = Liabilities 850,000 + Owners Equity 425,000.

This formula is known as the accounting equation. Assets and liabilities are
further subdivided as current and non-current to help stakeholders

understand their expected time frames. i.e. Debts due within the next 12
months are current liabilities just a assets that can be readily converted into

cash are current assets. All else is classified as non-current.

The total amount of the Owners Equity (also known as the Net Worth of

the company) is the

amount of money that would be left over if all the Assets were sold

and the external funders (Liabilities) were paid out. This is the first and
obvious read of a Balance Sheet in relation to the company's financial

strength. i.e. it quantifies how much the business is worth from an

accounting point of view. Note: an accounting point of view does not take

into account future profit potential and values assets at the time of
purchase not what they might be worth today. Owners Equity is typically

made up of the shareholders/owners initial and subsequent investments

(Capital), the past profits that have not yet been distributed to the

shareholders/owners (Retained Earnings) and the profits from the current

trading period (Current Earnings).

Reading a Balance Sheet using Financial Ratios

Reading about the financial strength of a business from a balance

sheet generally requires a certain amount of analysis and comparison,

as well as access to the other financial report, the Income Statement.

This analysis is called the Financial Ratio and Trend analysis. By comparing
this period's calculated ratios with prior periods and industry

benchmarks, allows you to identify healthy/unhealthy trends in the

financial strength of the company in relation to its past and the

industry in general i.e. whether the returns from the business are
competitive with other investment options, whether the company is

becoming more or less profitable, more or less dependent on external

funders, better or less able to meet its financial obligations when they

become due or more or less efficient at managing the assets of the

company. There are many different types of financial ratios but they are

generally grouped into:

More Loan – More interest payment- Liability increase- High default

risk

 Leverage Ratios - which calculate the extent to which the

company uses external debt in its capital structure rather than

equity funders. Over reliance on external debt makes a

company's profitability vulnerable to interest rate raises and is

more vulnerable to liquidation actions by creditors during a

downturn. The most common leverage ratio is the debt to equity

ratio. Using the example above it would be ... Total Debt 850,000 /

Total Owners Equity 425,000 = 2.0 i.e. for every $1 that the owners
have invested, external funders have committed $2. This company

would be considered highly geared (leveraged) 850000/425000=

2:1 3:1

 Liquidity/Solvency Ratios - which calculate the company's

ability to pay its current liabilities as they become due from

current assets. Some companies might be profitable but yet

unable to pay critical payments like staff, loan repayments or rent

because their money is tied up in debtors (money owned to the

 company by customers) or inventory. The most common

Liquidity/Solvency Ratio is the Quick ratio. Using the example above

it would be ... (Current assets 355,000 - Inventory $250,000) /

Current Liabilities 150,000 = 0.70 i.e. for every $1 due for payment
in the next month or so, the company has $0.70 in liquid (cash or

soon to be cash) assets. Generally a Quick ratio of 1.00 is

considered a safe operating ratio.

 Activity/efficiency/Operational Ratios - which calculate the

efficiency of company's management in its operations and use

of assets. Typical efficiencies deal with stock turn into cash and
debtor days converted into cash which measures respectively, the

amount of stock required to achieve sales targets and how many

days it takes to get paid by customers. Generally you would not

want to over stock and you would want your debtors to pay in
the shortest possible time.

 Profitability Ratios - which calculate the return on sales and

capital employed. These ratios are usually expressed as a % and

monitored over time periods to identify healthy/unhealthy trends.

Typical % are Gross Profit as a % of sales, Net Profit as a % of sales,

Net Profit as a % of Assets, Net Profit as a % of Owners Equity.

Using the example above, Net Profit as a % of Assets would be ...

Current earnings $75,000 / Total Assets 1,275,000 = 5.9% and Net

Profit as a % of Owners Equity would be ... Current earnings $75,000
 / Total Owners Equity 425,000 = 17.6%. i.e. if competing investment

opportunities provide a lower return than these, then the

investment in this business remains worthwhile.

In summary, by comparing these ratios with prior periods, commonly

agreed safe operating levels and industry benchmarks helps you read about

the changing financial strength/health of a company from the Balance

Sheet report.
As lender

As Creditors

As Shareholders

Profit before Interest Rs. 100,000 100,000

Interest Payment 70,000 110,000 10,000