It's a common misconception among students that only professional accountants need to know how to read balance sheets, but that's like saying that only bankers should be able to read bank statements. In actual fact, core accounting skills are required within a number of professions: investment management, corporate finance and corporate law to name but a few.
The second mistake people make is thinking that there is something intrinsically difficult about interpreting a firm's financial accounts. The balance sheet is little more than a snap shot of a company's financial performance at any given period in time. It is designed to be interpreted without requiring specialised knowledge. They do, however, take time to get to know. If you want to be able to read beyond the profit and loss column of a company's accounts then this is worth doing.
The balance sheet has three main elements: the company's assets, its liabilities and the equity held by its shareholders. These three things are linked by a simple equation, from which we get the term 'balance' itself:
Assets - Liabilities = Shareholders' equity
The value of a company's assets must always be in balance with the value of its liabilities, plus the equity owned by its shareholders.
For example, if a business has assets of 100,000 and liabilities of 25,000 then its net worth (or shareholders' equity") is equivalent to 75,000.
100,000 - 25,000 = 75,000
Alternatively, a business which is under-performing might have assets worth 100,000 and liabilities of 175,000, leaving it with net worth of negative 75,000.
100,000 - 175,000 = -75,000
So, basics out the way, let's take a look at the different parts of the balance sheet and their sub-components. While the ordering and terms of the various subsections may vary slightly between companies and the accounting systems of different countries, the layout is more or less universally applicable and the outline presented here can be seen as a fairly standard guide.
These are a company's goods, and include anything owned by or owed to the company that is deemed to have a value.
Assets are divided into two categories: current assets and all other assets, which together make up a business's total assets.
Current assets (sometimes referred to as liquid, working or floating assets) include all assets that are cash or can be converted into cash in a short period of time (typically 12 months). Measuring a firm's current assets, or liquidity, is important in evaluating how adept a company will be at managing a downturn or a period where their day-to-day income declines for whatever reason.
Current assets are sub-divided into categories. These are generally listed on the balance sheet in order of liquidity (the ease and speed in which they can be turned into cash). So, without further ado:
Cash and cash equivalents
These include cash and other types of highly liquid assets, such as government bonds with a three-month maturity, or credit agreements with a bank.
A business which has a ready supply of cash is referred to as cash-rich" and is generally well regarded by investors, except in certain circumstances: for example, if the company has recently sold one of its businesses and/or its bond portfolio and has therefore depleted its overall value.
Inventory means goods or products owned by the company which can be sold to customers or vendors at a later date (within the coming 12 months). Remember, a balance sheet is a snapshot of a company's accounts at a given point in time, so the company's inventory will vary greatly throughout the year. For example, a Christmas card manufacturer will begin stocking up around summertime to be ready to offload stock to stores in early autumn, at which point the business's inventory will decrease in value and its cash will rise.
Receivables are basically cash sums owed to the company which have yet to be paid (or received). When a company sells its product to a supplier, payment isn't received straight away but rather after an invoicing period generally lasting 30 days (though in some cases this may be longer or shorter).
In competitive markets, companies may attempt to gain an advantage over their rivals by offering wider payment windows to clients.
By the opposite token, a business may also pay upfront for goods or services which it will not receive until a later date. As soon as they are paid for they become assets of the company.
Other current assets
An umbrella term for other income due to be received by the company within the next 12 months, for example tax repayments.
Non current assets, as the name would suggest, are assets which cannot readily be turned into cash and so are considered illiquid. These include:
Property / plant / equipment
Property, machinery and other forms of equipment will be reported on a business's balance sheet as assets.
They are valued at their original cost minus depreciation (the amount the equipment has devalued by since it was first bought). As a piece of equipment wears with age or is usurped by newer, more efficient models, its value is slowly whittled down year by year until it is eventually replaced.
Goodwill is a term used to describe the excess amount paid by a business to acquire another company, or one of its assets, above its book value or market price.
For example if company X pays 120,000 for company Z with a book value of 100,000, the goodwill value is 20,000 which business X carries onto its balance sheet.
Why would they pay above the asking price? If company Z has a strong reputation built up over 30 years than Z may have a value which is greater than merely the sum of its parts.
Goodwill is gradually removed from a balance sheet over a period of years in even chunks so as to cause less disruption to the company's accounts, much in the same way as accumulating depreciation. This process is called amortisation.
Intangible assets are essentially assets which don't physically exist, for example trademarks, patents, copyrights and brand names.
One important point to note is that these assets only include those which have been acquired from a third party and have been assigned a fair value". If a company were to value its own intangibles, as used to be the case, they could easily be grossly overvalued.
A company may have a number of long-term investments such as shares, bonds or property which it plans to hold on its balance sheet for a period longer than 12 months. These assets are carried onto the balance sheet at their cost price. They remain at this price even if their market value rises in time for the next reporting period.
Other long-term assets
Another category for grouping miscellaneous assets, this time ones that don't fall under the categories listed above and which will only realise their value after 12 months or more.
Again, liabilities are divided between the current and the long-term.
Current liabilities include the debts and obligations owed by a business and due for payment within the coming 12 months. These are separated into the following sub-categories:
This is cash owed to suppliers for goods they have provided upfront in return for later payment within a maximum 12 months period. This is essentially the reverse of receivables in the current assets column.
Accrued expenses are costs which the company has incurred, such as staff wages and rent, but for which they have not yet been invoiced. For example, workers tend to be paid at the end of the month after they have already provided four weeks labour without payment. The business cannot ignore this so it carries it onto the balance sheet as an accrued expense.
This is money owed by a company to the bank or another organisation which it is under obligation to repay within 12 months.
Generally speaking, short-term debt is cheaper to finance than long-term debt as it tends to carry a lower interest rate. As such, financial organisations have long discovered the trick of borrowing debt cheaply in the short-term (say at 4 per cent) and lending it out long-term at a higher rate (eg 7 per cent).
This practice works swimmingly until the company X's short-term creditors asks for their debt back leaving X (who has leased all its assets out long-term) without any liquidity. This is essentially what led to the demise of Bear Stearns - the first major casualty of the credit crisis in 2008.
Non current liabilities are liabilities which don't have to be paid in the coming 12 months. They include:
Long-term debt is debt maturing at any point after one year. Companies may feel the need to borrow money over a longer period in order to expand their business, replace equipment or make acquisitions, so large amounts of debt on a balance sheet may not be a cause for alarm but rather the sign of an ambitious organisation. However, a company's debt must be weighed against its earning power and its ability to pay off this debt within a relatively short period if called upon.
As the name suggests, this is tax which is owed but does not need to be paid within the next 12 months.
Rather more complicated, this sub-heading only comes into use when a company buys a significant portion (80 per cent or more) of another business's shares. When this happens company X (in this case buying 90 per cent of Z's stock) is able to carry 100 per cent of the total assets and liabilities of Z onto its balance sheet, recording it under the appropriate headers.
What happens to the 10 per cent it hasn't bought yet? The minority interest section balances the equation by recording 10 per cent of Z's value as a liability so that the sheet as a whole reflects the true percentage of the stock acquired.
Another catch-all category where miscellaneous debts are recorded such as unpaid fines and tax obligations.
Referring back to the original equation assets - liabilities = shareholders' equity, by subtracting a company's total liabilities from its total assets you are left with its net worth, essentially the extra money it has sloshing about from trading which is not used in the day-to-day running of the business.
This value is also known as shareholders' equity. In the case of any company that has shares issued in its name, the company belongs to a series of individuals (shareholders) who have invested money in the company in return for a slice of its worth, ie equity.
Unlike debt there is no obligation for the company to pay this money back, hence it is not listed under liabilities. The company is able to use this cash for whatever it pleases, though this doesn't mean that the equity-holders don't get a say in how the company is run, as we shall soon discover.
This equity is listed on the balance sheet as either preferred stock or common stock.
Preferred stock is the stock that belongs to shareholders who don't have voting rights. On the plus side, they always receive a dividend (a portion of the company's profits which is paid out to shareholders depending on how much equity they own) and have priority over common shareholders if the company goes bankrupt.
Because businesses are obliged to pay out a dividend for every preferred share they issue (even if the company makes a loss), they generally prefer not to have too many of them on their balance sheet.
Common stock is equity belonging to the owners of the company; the people who have voting rights allowing them a say in hiring / firing from the board and some other aspects of company strategy. Common Stock holders are understood to have the company's best interests at heart and as such only receive a dividend if the board votes to pay one.
Additional paid in capital
When shares are first issued they have a par value - an original value at which they are recorded on the balance sheet under the categories above. As the shares rise, the excess value is booked as paid in capital.
Example: company X has preferred stock with a par value of 25 per share which its sells to the public at 50. It lists 25 on the balance sheet under preferred stock and the excess 25 is booked as paid in capital.
Retained earnings are simply the company's net earnings which are invested back into the business rather than paid out as dividends. As explained above, common shareholders may choose not to pay a dividend if they feel the money is better spent being put back into the business in order to fund further expansion and/or acquisitions over the year ahead.
The company may also use this money to buy back stock it has issued in order to reduce the number of shares in its name and so increase the company's earnings per share.
However, if the company loses money rather than making a profit, meaning its liabilities are greater than its assets, it will be left with negative retained earnings which will be booked on the balance sheet as a negative value.
When a company decides to buy back a portion of its issued shares it can do one of two things. It can either cancel the shares so they no longer exist or alternatively it can retain them, effectively keeping them on ice in case it chooses to issue them at a later date. Should it opt for the latter, the value of the shares stays on the balance sheet as a negative figure.
As they are inactive, shares held as treasury don't receive a dividend or any voting rights.