Have you ever been through an ECG or echo test? It tells the status of your cardiovascular health. The comparison may seem too far-fetched but in truth, a balance sheet has a similar purpose. It tells the health status of your company, including the assets, owner’s equity, IQE share price and more.
When you combine your firm’s balance sheet with the cash flow and income statement, you get what we call the cornerstone of your financial statements. For potential investors or shareholders of companies, it is imperative to know how to read and understand a balance sheet.
Understanding a balance sheet helps you in multiple other ways:
- It helps potential investors in their decisions of investing in a company
- A balance sheet helps employees optimize their processes so they can contribute better to their shared organizational goals
- Business owners can use the balance sheet to craft better organizational strategies
But a balance sheet is one of the trickiest pieces of documents and understanding it takes some work. Keep reading to learn about the mechanics of how it works. But first learn about what a balance sheet is.
Balance Sheet- What it is
A balance sheet is a reflection of the book value of a company. It is a financial document that communicates the worth of your organization or company. It provides you with all this information by tallying up and listing out your firm’s assets, owner’s equity, liabilities etc. of the reporting date.
Your service providers typically prepare or distribute the balance sheet on a monthly or quarterly basis. Your firm’s policy or perhaps the laws governing the business may also determine the frequency of the report. However, the gist of it is that your company’s balance sheet summarizes the status of your business at a point.
The financial document breaks down your financial position into liabilities, assets and equity. You may consider it as a snapshot of the current status. Now there are several ways of interpreting this financial document.
- It gives insight into the progress or failure of a company when a business leader reviews it internally. When an internal audience gathers this vital insight, it helps them twist and adjust their approach and policies to correct failures, double the successes etc. A balance sheet also shows the space a company has for reaching for new opportunities.
- When an external party reviews a balance sheet, out of an interest in the company, it helps them draw intel. They find out information concerning the resources a company has and how it has been utilizing those resources. It helps the external party see how the company is also financing those resources. With this information, they can decide how profitable or unprofitable it would be to invest in your company. Besides this, the information out of a balance sheet helps calculate vital metrics, including debt-to-equity ratio, profitability and liquidity.
Balance sheets are also vital sources of information for external auditors. It helps them ensure compliance of a firm with reporting laws and other governing authorities the company subjects to.
Understanding the Equation of a Balance Sheet
There is a simple equation or formula for a balance sheet. You will typically find it in two parts due to the equation. The rule for this financial document is that both parts of the document must balance each other out.
Balance Sheet Equation:
Assets = Liabilities +Shareholders Equity
Now if you consider your firm’s balance sheet, its readings must show that your company’s financial obligations are balancing its assets. The latter are the means your company uses for its business operations. Therefore, it is imperative for not only the liabilities but also the equity investment to balance out the assets in holdings.
Like we said, assets are your firm’s resources while the financial obligations and equity support your assets. Also, the owner’s equity is what you initially invested in the company, meaning the sum of money you put in. On a balance sheet, this amount shows in addition to the retained earnings, depicting as a source of funding for your business.
The formula we mentioned above is the most common one auditors use to compile your balance sheet at a given time. However, there are some other equations that professionals use too, to compile the information.
The other equations you may find include:
Liabilities = Assets – Owner’s Equity
Owners’ Equity = Assets – Liabilities
Many may find this ironic, but the reason why this financial document is called a balance sheet is because IT HAS TO balance the figures. With that said, let’s run through the listings under the three categories on a balance sheet: assets, liabilities and owners’ equity.
Anything that your company owns and we can define it as a quantifiable and inherent value is an asset. There exists the liquidation process that any given time, can help convert your firm’s assets into cash. A balance sheet will state your assets as positives (+) in sub-categories.
The sub-categories include the current assets and non-current assets that can typically convert into cash at any time during the business year.
In accounting, it wouldn’t be wrong to define assets and liabilities as antonyms. While assets mean what you own, liabilities show what your firm owes. They are the financial and legal obligations your company must pay for a debtor.
This is why the balance sheet states liabilities as negatives (-). They too have sub-categories of current and noncurrent liabilities.
You can refer to this category as either shareholder’s equity or owner’s equity. Under this section, you will find a list of all that belongs to your business after it has accounted for its liabilities. The simplest way of measuring your owner’s equity is by adding all the assets your company owns and subtracting the total amount of liabilities.
The residual value is the total of owner’s equity.
A balance sheet is a financial report that you receive after a set period, depicting your firm’s current financial health. It helps companies assess their progress or failure and their financial standing at a point. The balance sheet states the assets of your company, which are also the resources that run it, minus the financial liabilities the firm has to pay. The document also reports the amount at a given time as the owner’s equity.