Guide to Reading

a Balance Sheet

by EXAFIN
www.exafin.net
 Guide to Reading
a Balance Sheet

INDEX

1. Introduction 4
1.1 Overview of balance sheets 4
1.2 Importance of understanding balance sheets 5

2. Understanding Balance Sheet Components 8

2.1 Assets 9
2.1.1 Current Assets 10
2.1.2 Long-term Assets 12
2.2 Liabilities 15
2.2.1 Current Liabilities 16
2.2.2 Long-term Liabilities 16
2.3 Shareholders' Equity 18
2.3.1 Common Stock 18
2.3.2 Preferred Stock 21
2.3.3 Retained Earnings 23

3. Analyzing Balance Sheets 26

3.1 Ratio Analysis 26
3.1.1 Liquidity Ratios 27
3.1.2 Solvency Ratios 29
3.1.3 Efficiency Ratios 30
3.1.4 Profitability Ratios 32

4. Limitations of Balance Sheets 34

4.1 Timing Issues 34

2
 Guide to Reading
a Balance Sheet

4.2 Valuation Issues 35

4.3 Omissions and Errors 37
4.4 Presentation Issues 38

3
 Guide to Reading
a Balance Sheet

1. Introduction
The Balance Sheet is an essential financial statement that provides
valuable information about a company's financial health.
Understanding how to read and analyze balance sheets is a critical
skill for investors, analysts and business owners alike.
However, interpreting balance sheets can be challenging,
especially for those who are not well-versed in accounting and
finance.

In this guide, we will provide a comprehensive overview of balance

sheets, including the different components, how to interpret
them and how to use them for financial analysis.
We will also highlight the limitations of balance sheets and how
to address them.
By the end of this guide, readers should have a solid
understanding of how to read and analyze balance sheets, as well
as practical applications of this knowledge.

1.1 Overview of balance sheets

A balance sheet is a financial statement that shows a company's
assets, liabilities and equity at a specific point in time.
The balance sheet provides a snapshot of a company's financial
position and is one of the three primary financial statements,
along with the income statement and cash flow statement.

Assets represent the resources a company owns or controls, such

as cash, accounts receivable, inventory, and
property/plant/equipment.

4
 Guide to Reading
a Balance Sheet

Liabilities represent the obligations a company owes to its

creditors, such as accounts payable, loans, and bonds payable.

Shareholders' equity is the value of a company's assets minus its

liabilities, representing the amount of money that would be left
over for shareholders if the company sold all its assets and paid
off all its debts.
It reflects the value that shareholders have in a company.

The balance sheet follows the fundamental accounting equation,

which states that assets must always equal the sum of liabilities
and equity.

ASSETS = LIABILITIES + EQUITY

This equation ensures that the balance sheet is always balanced:

hence the name.

The balance sheet is an essential tool for assessing a company's

financial position and evaluating its ability to meet its
obligations.
It is used by investors, analysts, creditors, and other stakeholders to
make informed decisions about a company's prospects and
financial health.

1.2 Importance of understanding balance sheets

Understanding balance sheets is essential for investors, analysts,
and business owners as it provides critical information about a

5
 Guide to Reading
a Balance Sheet

company's financial health. The balance sheet provides a snapshot

of a company's financial position, allowing stakeholders to assess
its ability to meet its obligations and generate profits.

Investors use balance sheets to evaluate a company's financial

performance and determine its investment potential. Analysts use
balance sheets to analyze trends, identify strengths and
weaknesses, and make recommendations to clients.
Business owners use balance sheets to monitor their company's
financial health and make informed decisions about growth and
investments.

Furthermore, balance sheets can be used to calculate financial

ratios, such as liquidity ratios, solvency ratios, and profitability
ratios: these ratios provide insights into a company's financial
performance and allow stakeholders to compare it to its peers or
industry benchmarks.

Understanding balance sheets also helps stakeholders identify

potential risks and challenges. For example, a high level of debt
on a balance sheet could indicate that a company is at risk of
defaulting on its obligations, while a low level of assets could signal
operational issues or poor management.

So… understanding balance sheets is crucial for making informed

decisions about investments, analyzing financial performance and
managing risk.
Without a solid understanding of balance sheets, stakeholders
may not have a complete picture of a company's financial health

6
 Guide to Reading
a Balance Sheet

and may make decisions that could negatively impact their

investments or business operations.

7
 Guide to Reading
a Balance Sheet

2. Understanding Balance Sheet Components

To fully get and interpret a balance sheet, it is essential to
understand its different components.
As said before, the balance sheet has three primary components:
assets, liabilities, and shareholder's equity.

Each component provides valuable information about a

company's financial position and performance.
In this chapter, we will explore each component in detail and
discuss how they are presented on a balance sheet.

Before jumping in analyzing each component, let’s see quickly

how a balance sheet for a hypothetical company would look like…

8
 Guide to Reading
a Balance Sheet

2.1 Assets
Assets are the resources that a company owns or controls, and
they are one of the three primary components of a balance sheet.
Assets provide valuable information about a company's financial
health and can be used to generate revenue.
Assets are typically categorized as either current or non-current
assets, depending on their expected use and lifespan.

9
 Guide to Reading
a Balance Sheet

In this section, we will explore the different types of assets and

their importance in assessing a company's financial performance.

2.1.1 Current Assets

Current assets are assets that are expected to be converted into
cash or used within one year.
These assets are important because they provide a snapshot of a
company's short-term liquidity and its ability to meet its current
financial obligations.
Current assets typically include cash, accounts receivable, and
inventory.

Cash
Cash is the most liquid of all assets and includes physical currency,
bank deposits, and highly liquid investments with a maturity of
three months or less.
Cash is used to pay for daily operating expenses, investments, and
debt payments.

Accounts Receivable
Accounts receivable are amounts that are owed to a company by
its customers for goods or services provided.
Accounts receivable are a sign of a company's sales, and an
increase in accounts receivable can indicate an increase in sales
activity.
Accounts receivable are typically expected to be collected within
30 to 90 days.

10
 Guide to Reading
a Balance Sheet

Inventory
Inventory represents the goods that a company has on hand for
sale or production.
This is an important current asset because it can be used to
generate revenue quickly.
However, holding too much inventory can tie up a company's cash
and reduce its profitability: it's important for companies to
manage their inventory levels to optimize their working capital
and minimize carrying costs.

Other current assets can be…

Cash equivalents: these are short-term investments that are
highly liquid and easily convertible to cash, such as money market
funds and commercial paper; they are usually reported together
with cash as “cash and cash equivalents”.

Prepaid expenses: these are payments made in advance for

goods or services that will be received in the future. Common
examples include prepaid rent, prepaid insurance premiums, and
prepaid subscription fees. It’s an asset because the cash has gone
out but the expense hasn’t been recognized in the income
statement yet: when it will be recognized as a cost in the income
statement, prepaid expenses will be written off.

Marketable securities: these are short-term investments that are

readily convertible to cash and have a maturity of less than one
year. Examples include stocks, bonds, and other securities in which
the company has invested.

11
 Guide to Reading
a Balance Sheet

Short-term loans: these are loans that are expected to be repaid

within one year; these loans are typically made to other companies
or individuals and may be secured or unsecured.

Deferred tax assets: these are tax assets that arise when a
company has overpaid its taxes or has tax credits that can be used
in future periods.

Other receivables: they are amounts owed to the company by

third parties, such as tax refunds or insurance claims.

Advances to suppliers or customers: these are advances made to

suppliers or customers for goods or services to be provided in the
future.

2.1.2 Long-term Assets

Long-term assets are assets that are expected to provide
economic benefits for more than one year (or that will turn into
cash in more than one year, as opposed to current assets).
These assets are typically held for use in a company's operations
rather than for resale and are classified as either tangible or
intangible.

Tangible Long-term Assets

Tangible long-term assets are physical assets that have a useful life
of more than one year and can be seen and touched.

12
 Guide to Reading
a Balance Sheet

Examples of tangible long-term assets include…

● Property, plant, and equipment (PP&E): this category includes
land, buildings, machinery, equipment, and vehicles that are
used in a company's operations. These assets are typically
depreciated over their useful lives;
● Natural resources: these are assets such as oil and gas
reserves, mineral deposits, and timber that are used in a
company's operations;
● Investment property: this is property that is held for the
purpose of earning rental income or capital appreciation.
Examples include rental properties and vacant land held for
development.

Intangible Long-term Assets

Intangible long-term assets are assets that lack physical substance
but have value to a company.

Examples of intangible long-term assets include…

● Goodwill: this is the excess of the purchase price paid for an
acquired company over the fair value of the net assets
acquired;
● Patents: they are exclusive rights granted by a government to
an inventor for a certain period of time to prevent others from
making, using, or selling an invention;
● Trademarks: these are symbols, logos, or names used to
identify and distinguish a company's products or services
from those of competitors;

13
 Guide to Reading
a Balance Sheet

● Copyrights: they are exclusive rights granted to authors,

artists, and other creators for their original works of
authorship, such as books, music, and software;
● Licenses: these are contractual rights to use a certain product
or technology that is owned by another company;
● Franchises: they are contractual rights to operate a business
using a certain brand name and business model that is
owned by another company.

Long-term assets generally lose their value year after year: the
method to account for it is “depreciation” for tangible assets and
“amortization” for intangible assets.
Depreciation is used for tangible assets such as buildings,
equipment and vehicles.
The cost of these assets is spread out over their estimated useful
lives, which is determined by the company based on factors such
as expected usage, wear and tear, and technological obsolescence.
Depreciation is recorded as an expense on the income statement,
which reduces the value of the asset on the balance sheet.
Amortization, on the other hand, is used for intangible assets,
such as patents, trademarks, and copyrights. These assets also
have a limited useful life, and the cost is spread out over that
period of time.
Like depreciation, amortization is recorded as an expense on the
income statement and reduces the value of the asset on the
balance sheet.

14
 Guide to Reading
a Balance Sheet

Both depreciation and amortization use different methods to

allocate the cost of assets over time: the most common methods
include straight-line, accelerated and units-of-production.
Straight-line depreciation and amortization allocate an equal
amount of the cost over each period of the asset's useful life, while
accelerated methods allocate more of the cost in the early years
of the asset's life. Units-of-production method allocates the cost
based on the actual usage of the asset.

2.2 Liabilities
In addition to assets, balance sheets also list a company's liabilities,
which represent its obligations to creditors and other stakeholders.
Liabilities are amounts owed by a company and are classified as
either current or non-current.

Understanding a company's liabilities is important because they

represent potential claims on its assets and can have a significant
impact on its financial health and ability to meet its obligations.
For example, a company with a large amount of debt may be at
risk of default if it is unable to generate sufficient cash flow to
make interest and principal payments, while a company with a
large amount of accounts payable may have difficulty paying its
suppliers on time if it experiences a cash flow shortfall.

In the following sections, we will discuss the different types of

liabilities that can appear on a balance sheet and what they
represent.

15
 Guide to Reading
a Balance Sheet

2.2.1 Current Liabilities

Current liabilities are obligations that are due to be paid within
one year or the company's operating cycle, whichever is longer.
These liabilities are typically settled using current assets such as
cash, accounts receivable, and inventory.

Examples of current liabilities include…

● Accounts payable: this represents amounts owed to suppliers
for goods and services that have been received but not yet
paid for;
● Notes payable: this includes short-term promissory notes that
a company issues to borrow money for a specific period of
time;
● Accrued expenses: these are expenses that have been
incurred but not yet paid, such as salaries, rent, and utilities;
● Short-term debt: this includes loans and other forms of debt
that are due to be repaid within one year;
● Income taxes payable: this represents the amount of income
tax that a company owes to the government but has not yet
paid;
● Customer deposits: this represents amounts received from
customers in advance of the delivery of goods or services.

2.2.2 Long-term Liabilities

Long-term liabilities are obligations that are due to be paid
beyond one year or the company's operating cycle, whichever is
longer. These liabilities are typically used to finance long-term

16
 Guide to Reading
a Balance Sheet

investments such as property, plant, and equipment, and are

generally settled using future cash flows.

Examples of long-term liabilities include…

● Long-term debt: this includes loans and other forms of debt
that are due to be repaid over a period of more than one year;
● Bonds payable: these are long-term debt instruments that a
company issues to raise capital;
● Pension liabilities: this represents the future obligation that a
company has to pay its employees' retirement benefits;
● Lease obligations: this represents the future payments that a
company is obligated to make under lease agreements for
property, equipment, or other assets.

Other types of long-term Liabilities that you may find in a

balance sheet are…
● Deferred tax liabilities: this represents the amount of taxes
that a company will owe in future years as a result of
temporary differences between the financial statement
reporting of assets and liabilities and their tax basis;
● Contingent liabilities: these are potential liabilities that may
arise in the future if certain events occur, such as lawsuits,
warranty claims, or environmental cleanup costs; given this
“dangers”, liabilities are chosen to be recorded by the
company’s accountant/financial department with the
estimation of probability and amount;
● Convertible debt: this is debt that can be converted into
equity (such as common stock) at a later date;

17
 Guide to Reading
a Balance Sheet

● Deferred revenue: this represents amounts that a company

has received from customers for goods or services that have
not yet been provided… so, cash has been received but
revenue has not been recognized yet… when it will meet the
criteria to be recognized, revenue will be recorded in the
income statement and deferred revenue will be written off.

2.3 Shareholders' Equity

Shareholders' equity is a key component of a company's balance
sheet, representing the residual interest in the assets of a
company after deducting its liabilities.
Essentially, shareholders' equity reflects the net worth of a
company, as it represents the value of the company's assets that
belong to its shareholders.

In this section, we will explore the different components of

shareholders' equity, including common stock, preferred stock,
and retained earnings.
By examining a company's shareholders' equity, investors can gain
insights into how the company is financing its operations, how
much value it has created for shareholders and what risks it may
face in the future.

2.3.1 Common Stock

This item is the main type of equity security that represents
ownership in a company.

18
 Guide to Reading
a Balance Sheet

When a company issues common stock, it sells ownership stakes

in the company to investors in exchange for cash or other assets.
The investors who purchase common stock become the
company's shareholders, and they are entitled to vote on
important company decisions such as electing board members
and approving mergers or acquisitions.

On a balance sheet, common stock is listed under shareholders'

equity.
The value of common stock is calculated by multiplying the
number of outstanding shares by the stock's “par value” per share.
“Par value” is the minimum price that a company can issue its
shares for, and it is typically a small amount such as $0.01 or $0.10
per share.

When a company issues common stock, the amount of money it

receives from investors is recorded as a credit to the common
stock account on the balance sheet: the corresponding debit is
usually recorded in the cash account, reflecting the fact that the
company received cash in exchange for the shares.

If a company decides to repurchase its own shares of common

stock, the value of the repurchased shares is deducted from the
common stock account on the balance sheet. This reduces the
total value of shareholders' equity and increases the company's
earnings per share (EPS).

Other concepts related to common stock to keep in mind are…

19
 Guide to Reading
a Balance Sheet

Dividends: Common stockholders may be entitled to receive

dividends, which are payments made by a company to its
shareholders. Dividends are usually paid out of the company's
earnings, and the amount of the dividend is typically determined
by the company's board of directors… when they’re paid, they
reduce retained earnings - another item of the equity section of
the balance sheet that we will analyze better.

Voting rights: common stockholders usually have the right to vote

on important company decisions, such as electing directors or
approving mergers and acquisitions. The number of votes each
shareholder has is typically proportional to the number of shares
they own.

Dilution: when a company issues new shares of common stock, it

can dilute the ownership interests of existing shareholders. This is
because the total number of shares outstanding increases, which
means that each individual share represents a smaller ownership
stake in the company.

Par value vs. market value: the par value of a company's common
stock is typically a nominal amount that has little relation to the
stock's market value. The market value of a stock is determined by
supply and demand in the stock market, and can fluctuate
significantly based on factors such as the company's financial
performance, industry trends, and macroeconomic conditions.

Capital structure: common stock is one component of a

company's capital structure, which also includes debt, preferred

20
 Guide to Reading
a Balance Sheet

stock, and other forms of financing. Understanding a company's

capital structure is important for investors and analysts, as it can
impact the company's cost of capital, risk profile, and overall
financial health.

2.3.2 Preferred Stock

Preferred stock is a type of equity security that typically has
preferential rights over common stock in terms of dividend
payments and liquidation preferences.
It may have a fixed dividend rate that is paid out before any
dividends are paid to common stockholders.
In addition, if a company is liquidated or goes bankrupt, preferred
stockholders may have priority over common stockholders in
terms of receiving assets from the company.

Some key characteristics of preferred stock include…

● Dividends: preferred stockholders are typically entitled to
receive a fixed dividend rate, which may be paid out quarterly
or annually. In some cases, the dividend rate may be
adjustable, based on a benchmark interest rate such as the
LIBOR;
● Liquidation preferences: preferred stock may have a senior
claim on a company's assets in the event of liquidation or
bankruptcy. This means that preferred stockholders would be
entitled to receive a certain amount of money before any
assets are distributed to common stockholders;
● Convertibility: some types of preferred stock may be
convertible into common stock at the option of the holder.

21
 Guide to Reading
a Balance Sheet

This can provide investors with the potential for capital

appreciation if the company's common stock price increases;
● Redemption: in some cases, a company may have the option
to redeem (or "call") its outstanding preferred stock at a
specified price. This can be beneficial for the company if
interest rates have fallen since the preferred stock was issued,
as it can allow the company to refinance its debt at a lower
cost;
● Cumulative vs. non-cumulative: preferred stock may be
cumulative or non-cumulative. Cumulative preferred stock
means that if a company fails to pay a dividend in one period,
it must make up the missed payments before paying any
dividends to common stockholders. Non-cumulative
preferred stock means that if a company fails to pay a
dividend in one period, it does not have to make up the
missed payments in future periods.

There are some potential disadvantages of preferred stock for

both issuers and investors…
● Limited upside potential: unlike common stock, preferred
stock typically does not have the same potential for capital
appreciation. This means that investors may miss out on
potential gains if the company performs well;
● Fixed dividend payments: while fixed dividend payments can
be attractive to investors who are looking for stable income,
they can also be a disadvantage in a low interest rate
environment. If interest rates rise, the fixed dividend rate on
preferred stock may become less attractive compared to
other investment options;

22
 Guide to Reading
a Balance Sheet

● Limited voting rights: preferred stockholders may not have

the same voting rights as common stockholders. This means
that they may not have a say in important company decisions
or be able to influence the company's strategy;
● Call risk: as mentioned earlier, some types of preferred stock
may be callable, meaning that the company has the option
to redeem the stock at a certain price. This can be a
disadvantage for investors if the stock is called when interest
rates are low, as they may not be able to find a similar
investment with the same yield;
● Subordination to debt: in the event of bankruptcy or
liquidation, preferred stockholders may be subordinated to
the company's debt holders. This means that they may not
receive the same level of payment as debt holders before the
remaining assets are distributed to shareholders.

2.3.3 Retained Earnings

Retained earnings are a component of shareholders' equity and
represent the portion of a company's net income that is not
distributed as dividends but instead is retained by the company
to reinvest in the business.

Retained earnings are calculated by subtracting the company's

(possible) dividends paid to shareholders from its net income.
The resulting figure is the amount of earnings that have been
retained by the company over the years since its inception.

23
 Guide to Reading
a Balance Sheet

Retained earnings can be used for various purposes, including

funding future growth initiatives, paying off debt, buying back
shares, or simply holding as a reserve for unexpected expenses.
The decision to retain earnings versus paying dividends is often a
strategic one made by the company's management and board of
directors.

Retained earnings are an important indicator of a company's

financial health and stability, as they represent the accumulated
profits of the business over time.
A company with strong and growing retained earnings may have
more flexibility to invest in its operations and withstand economic
downturns.

Other possible items that may be included under shareholder's

equity on a company's balance sheet are…
● Treasury stock: this represents shares of a company's own
stock that it has repurchased from shareholders. Treasury
stock is often held as a reserve for potential future use or
retirement; it’s reported as a deduction to the common stock
account;
● Additional paid-in capital: this is the amount of capital that
has been raised through the sale of stock above its par value.
This can include proceeds from the issuance of preferred
stock or common stock;
● Accumulated other comprehensive income: this includes
gains and losses that are not part of a company's normal

24
 Guide to Reading
a Balance Sheet

operations, such as unrealized gains or losses on investments

or foreign currency translation adjustments.

25
 Guide to Reading
a Balance Sheet

3. Analyzing Balance Sheets

Analyzing a company's balance sheet can provide valuable
insights into its financial health and performance.
As we have seen, a balance sheet summarizes a company's assets,
liabilities, and shareholder's equity at a specific point in time,
providing a snapshot of its financial position: by analyzing the
composition and changes in a company's balance sheet over time,
investors and analysts can gain a deeper understanding of its
financial strength, liquidity and overall performance.
In this chapter, we will explore some common analytical
techniques and ratios used to interpret and evaluate balance
sheets.

3.1 Ratio Analysis

Ratio analysis is a method of analyzing a company's financial
statements to evaluate its performance and financial health. Ratios
can be calculated using data from the balance sheet and other
financial statements.
Let’s see some of the commonly used ratios that can be calculated
from the balance sheet of our example.

26
 Guide to Reading
a Balance Sheet

3.1.1 Liquidity Ratios

Liquidity ratios measure a company's ability to meet its
short-term obligations with its current assets.
These ratios are important because they help assess a company's
ability to pay off its debts and remain financially stable.

The most commonly used liquidity ratios are…

27
 Guide to Reading
a Balance Sheet

Current ratio
It is calculated by dividing current assets by current liabilities.
In the given example, the current ratio would be 2.33 ($350/$150),
indicating that the company has 2.33 times more current assets
than current liabilities… so the company can more than cover its
short-term obligations!

Quick ratio
Also known as the acid-test ratio, it is calculated by dividing
current assets minus inventory by current liabilities.
This ratio provides a more stringent assessment of a company's
ability to pay off its short-term obligations. In the given example,
the quick ratio would be 1 (($350-$200)/$150), indicating that the
company has enough current assets besides inventory to cover its
short-term liabilities.

Cash ratio
It is calculated by dividing cash and cash equivalents by current
liabilities. This ratio measures a company's ability to meet its
short-term obligations with its most liquid asset, cash.
In the given example, the cash ratio would be 0.33 ($50/$150),
indicating that the company’s cash covers 33% of the current
liabilities.

These liquidity ratios help investors and creditors determine

whether a company can meet its short-term obligations, and if it
can remain financially stable.

28
 Guide to Reading
a Balance Sheet

A high ratio indicates that a company has sufficient current assets

to meet its current liabilities and can pay off its debts on time,
while a low ratio indicates the opposite.

3.1.2 Solvency Ratios

Solvency ratios are financial ratios that measure a company's
ability to meet its long-term obligations. They provide
information on a company's financial strength and its ability to pay
back its long-term debts.

The following are some commonly used solvency ratios:

Debt-to-Equity Ratio
This ratio measures the proportion of debt and equity that a
company uses to finance its assets.
It is calculated by dividing total liabilities by shareholder's equity.
In the example, the debt-to-equity ratio would be 1.5 (total
liabilities of $600,000 divided by shareholder's equity of $400,000)
and it means that debt is 150% of equity.
Considering that this ratio has to measure the company’s ability to
cover long-term debt, we can choose as numerator Long-term
debt + Bonds Payable: this would give a result of 1.125.

Debt-to-Assets Ratio
This ratio measures the proportion of a company's assets that are
financed by debt.
It is calculated by dividing total liabilities by total assets.

29
 Guide to Reading
a Balance Sheet

In the example balance sheet given, the debt-to-assets ratio would

be 0.6 (total liabilities of $600,000 divided by total assets of
$1,000,000), so 60% of the total assets are financed by third parties
through diverse typologies of debt.

Other types of solvency ratios are calculated with the income

statement, such as Interest Coverage Ratio and Fixed Charge
Coverage Ratio.

3.1.3 Efficiency Ratios

Efficiency ratios measure how effectively a company is utilizing its
assets to generate revenue. These ratios are important because
they help investors and analysts assess the company's operational
efficiency, asset management, and revenue generation.

We have for example…

Inventory turnover ratio

This ratio measures the number of times a company sells and
replaces its inventory over a specific period. It is calculated by
dividing the cost of goods sold by the average inventory value.

The formula is…

Inventory Turnover Ratio =

Cost of Goods Sold / Average Inventory Value

30
 Guide to Reading
a Balance Sheet

Let’s suppose that at the beginning of the period analyzed

Inventory was 250 and that Cost of Goods Sold (seen in the income
statement of the hypothetical company) was equal to 1,500. This
means that, in the period analyzed, inventory has been sold and
replaced 6.7 times [1,500/(200+250)/2].

Accounts receivable turnover ratio

This ratio measures the number of times a company collects its
accounts receivable over a specific period. It is calculated by
dividing the total credit sales by the average accounts receivable
value.

The formula is…

Accounts Receivable Turnover Ratio =

Credit Sales / Average Accounts Receivable Value

Supposing that our company had A/R of 150 at the beginning

period and that Credit Sales were 2,500, then A/R have been
collected 20 times in the period analyzed [2,500/(100+150)/2].

Accounts Payable Turnover Ratio

The accounts payable turnover ratio measures how quickly a
company pays its suppliers or vendors.
It is calculated by dividing the cost of goods sold by the average
accounts payable balance during a given period, like this:
Accounts Payable Turnover Ratio =
Cost of Goods Sold / Average Accounts Payable

31
 Guide to Reading
a Balance Sheet

Assuming that COGS, as seen before, was 1,500 and that at the
beginning of the period A/P was 200, the ratio for our company is
equal to 10 [1,500/(100+200)/2].

Asset turnover ratio

This ratio measures the amount of revenue a company generates
for each dollar of assets it owns.
It is calculated by dividing the total revenue by the total assets, like
this:

Asset Turnover Ratio = Total Revenue / Total Assets

Supposing that Revenue (as Credit Sales of the previous example)
was 2,500, then this ratio for our company is equal to 2.5
(2,500/1,000), so for each dollar of asset that the company invests
in, 2.5 dollars are earned.

3.1.4 Profitability Ratios

Profitability ratios measure a company's ability to generate profits
and returns for its shareholders.
These ratios are important for investors as they indicate how well a
company is performing and whether it is generating enough
profits to sustain its operations and growth.

These ratios combine the analysis of balance sheet and income

statement: even if we are not analyzing the latter, let’s see some
profitability ratios and their formulas.

32
 Guide to Reading
a Balance Sheet

Return on Equity (ROE)

It measures the return generated by the company on the
shareholders' investment. It is calculated as net income divided by
total shareholder's equity. Using the previous example balance
sheet, the ROE would be:
ROE = Net Income / Total Shareholder's Equity.

Return on Assets (ROA)

This one measures a company's profitability by showing how
efficiently it utilizes its assets to generate earnings.
ROA = Net Income / Total Assets.

33
 Guide to Reading
a Balance Sheet

4. Limitations of Balance Sheets

While balance sheets can provide valuable insights into a
company's financial position, it is important to recognize their
limitations.
Balance sheets are only a snapshot of a company's financial
status at a specific point in time and do not provide a complete
picture of its financial performance or future prospects.
Moreover, certain items on the balance sheet, such as intangible
assets or contingent liabilities, may not be accurately reflected or
may be difficult to quantify.
In addition, balance sheets do not capture qualitative factors, such
as management competence or industry trends, which may be
critical in assessing a company's long-term prospects.
Therefore, investors and analysts should use balance sheets in
conjunction with other financial statements and qualitative
information to gain a more comprehensive understanding of a
company's financial health.

4.1 Timing Issues

One of the main limitations of balance sheets is that they only
provide a snapshot of the company's financial position at a specific
point in time. As a result, any changes in the company's financial
position that occur after the balance sheet date will not be
reflected in the balance sheet.

For example, if a company received a large order just after the

balance sheet date, the revenue from that order would not be
included in the current period's balance sheet. Similarly, if a

34
 Guide to Reading
a Balance Sheet

company had a significant expense just after the balance sheet

date, it would not be reflected in the current period's balance
sheet.

Timing issues can also affect the accuracy of some of the balance
sheet items. For example, the value of inventory recorded on the
balance sheet may not be accurate if it has become obsolete,
damaged or has decreased in value since the balance sheet date.
Similarly, the value of fixed assets such as property, plant, and
equipment may be inaccurate if they have been impaired or
depreciated since the balance sheet date.

So… timing issues are an important limitation to keep in mind

when analyzing a company's balance sheet, as they can impact
the accuracy and usefulness of the information presented.

4.2 Valuation Issues

While the balance sheet provides a snapshot of a company's
financial position, it is subject to various valuation issues. The
values of assets and liabilities are often based on estimates and
assumptions, which may not always be accurate. Here are some of
the common valuation issues:

Depreciation and Amortization: The values of fixed assets, such as

property, plant, and equipment, are reduced over time due to
depreciation. Similarly, the values of intangible assets, such as
patents and copyrights, are reduced over time due to
amortization. The method of depreciation or amortization used

35
 Guide to Reading
a Balance Sheet

can affect the value of these assets and, in turn, the overall value of
the company.

Inventory Valuation: The value of inventory on the balance sheet is

based on the cost of goods sold, which is subject to various
assumptions, such as the cost flow assumption (FIFO, LIFO, etc.)
and the valuation method (historical cost, lower of cost or market,
etc.). Changes in these assumptions can lead to significant
changes in the value of inventory.

Goodwill: Goodwill is an intangible asset that represents the excess

of the purchase price over the fair value of the net assets acquired
in a business combination. The value of goodwill is subject to
impairment testing, which involves estimating the fair value of the
reporting unit and comparing it to the carrying value of the unit,
including goodwill. Changes in these estimates can lead to
impairment charges and significant changes in the value of
goodwill.

Accruals: Accruals, such as accounts receivable and accounts

payable, are subject to estimation and may not reflect the actual
amounts that will be received or paid. Changes in these estimates
can lead to significant changes in the value of these accruals and,
in turn, the overall value of the company.

Market Value: The value of assets and liabilities on the balance

sheet may not reflect their current market value. For example, the
value of long-term debt may be based on historical interest rates
and not reflect the current market rates. Similarly, the value of

36
 Guide to Reading
a Balance Sheet

investments may be subject to market fluctuations and not reflect

their true value.

So… the valuation issues associated with the balance sheet can
limit its usefulness as a standalone financial statement. It is
important to consider these issues and use other financial
statements, such as the income statement and statement of cash
flows, to gain a better understanding of a company's financial
position.

4.3 Omissions and Errors

Despite the importance of balance sheets in understanding a
company's financial health, there are potential issues related to
omissions and errors that can affect the accuracy and reliability of
the information presented.

One common issue is the omission of certain assets, liabilities, or

equity items. For example, a company may not include certain
off-balance sheet items, such as operating leases or contingent
liabilities, which could significantly impact its financial position.
Additionally, a company may not include all relevant information
regarding its investments, intangible assets, or inventory, leading
to inaccurate valuation.

Errors can also occur due to mistakes in accounting or data entry.

For instance, a company may record a transaction incorrectly,
leading to incorrect financial statements. Inaccurate inventory

37
 Guide to Reading
a Balance Sheet

counts or improper classification of assets can also lead to errors in

financial reporting.

It is important to note that not all omissions and errors are

intentional or fraudulent. In some cases, they may be the result of
honest mistakes or misunderstandings. Nevertheless, these issues
can still impact the usefulness and reliability of the balance sheet
in decision-making.

To mitigate the risk of omissions and errors, companies can

implement strong internal controls, regularly review their financial
statements, and conduct independent audits. Investors and
analysts should also carefully review and analyze the balance sheet
for any potential issues or discrepancies.

4.4 Presentation Issues

Presentation issues refer to the way the information is presented
in the balance sheet. While the balance sheet is supposed to
provide an accurate and comprehensive view of a company's
financial situation, the way in which the information is presented
can sometimes be misleading. Some of the common presentation
issues that can limit the usefulness of the balance sheet include:

Grouping of Assets and Liabilities: Assets and liabilities are often

grouped together in the balance sheet according to their liquidity,
with current assets and liabilities appearing first, followed by
non-current assets and liabilities. However, this can sometimes
obscure important information, such as the relationship between

38
 Guide to Reading
a Balance Sheet

long-term assets and long-term liabilities, or the composition of a

company's inventory or accounts receivable.

Valuation Methods: The balance sheet relies on various valuation

methods to determine the value of assets and liabilities. For
example, tangible assets are typically valued based on their
historical cost, which may not reflect their current market value.
Similarly, intangible assets are often valued based on estimates of
their future cash flows, which can be difficult to predict accurately.
These valuation methods can sometimes lead to inconsistencies
and inaccuracies in the balance sheet.

Footnotes and Disclosures: these are additional information

included in financial statements to provide further details about
the items presented in the balance sheet, income statement, and
cash flow statement. These disclosures can include information
about accounting policies and methods, contingencies and
commitments, significant events that have occurred since the end
of the period covered by the financial statements, and other
relevant information that may be useful to users of the financial
statements.
Footnotes and disclosures can be an important tool for
understanding the financial position and performance of a
company. They can provide additional context and help users of
the financial statements better understand the underlying
financial data presented in the statements. For example, if a
company uses a different accounting method for a particular asset
or liability than is commonly used in the industry, the disclosure in
the footnotes can explain the reasoning behind the company's

39
 Guide to Reading
a Balance Sheet

choice and provide additional information about the impact of the

choice on the financial statements.
However, it's important to note that footnotes and disclosures are
not a substitute for the financial statements themselves. While
they can provide additional information and context, they should
not be relied upon as the primary source of information about a
company's financial position and performance. Users of financial
statements should always refer to the financial statements
themselves and seek professional advice if necessary.

40
 Guide to Reading
a Balance Sheet

Check us out on:

www.exafin.net

41