If you ever tried to read a company’s annual financial statements and landed upon daunting looking tables with numbers, then one of those was its balance sheet.
Now, basically, a balance sheet is used by potential investors, market experts, and existing investors to understand what is actually happening with the company. Balance sheet analysis helps investors assess the assets, understand the liabilities and calculate the company’s net profit/loss. In very simple terms, a balance sheet of a company shows the money it owns, the money it owes, and their subtraction shows the net worth of the company.
Financial experts are obsessed with balance sheet analysis because it is one of the three financial statements that can convince investors to invest their hard-earned money in someone else’s business.
It will help gauge the company’s performance at a particular point in time (which can be compared to past results) and understand if it will be their money’s worth on not.
So, to answer the question of how to analyse a balance sheet, let’s look at its different elements and understand their work play.
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As already mentioned, assets mean the money owned – the company’s wealth. If you look at it from a personal perspective, the real estate, property, vehicles, bonds, savings, mutual funds, reputation, etc are all your assets. And when you look at it from the company’s perspective, long-term assets like land, buildings, machinery, resources, etc and short-term accounts like cash, inventory, supplies, accounts receivable, short-term investment, etc all become its assets.
And from an investor’s perspective, when a company puts forth it’s assets on display it will help them understand what it actually owns. What all these above accounts add up to after the deducting deprivation, adding goodwill, etc will show the investors how much it owns.
Again, as already mentioned, a liability is what the company owes.
In personal terms, it would mean loans, debts, etc., liabilities for a company include borrowed capital, the creditors, equity capital, accrued income taxes, accounts payables, minority debts, loan interest repayment, etc. What the balance sheet illustrates is the increase or decrease in liability from the previous year and also helps to calculate if the company’s resources are sufficient for credit or debt repayment.
The difference between the assets and liabilities will show the worth. The total of assets and liabilities will always tally, obviously but that total isn’t considered by investors as it doesn’t reflect the companies calibre.
Balance Sheet Analysis always involves the comparison of current assets with current liabilities, debtors with creditors, income with expenditure, debt with shareholder equity, etc. And this can be done at various points in time, helping the investors to decide if they want to invest in the company or not. And if yes, for how long because a balance sheet also helps learn –
- The increase/decrease in short-term cash
- The number of tangible assets
- The dividends for equity shareholders, and other investors
- Average interest the company pays on debts
But why Balance Sheet and why the Analysis?
We have to mention the fact that all businesses are required to maintain accounts of some kind and more often than not, a balance sheet. If not for publishing them, then to calculate their own worth. But, when a company decides to go public i.e., when owners and other people invest in it by buying shares they become ‘shareholders’, it has to publish its financial statements.
The governments make it mandatory that these public companies release financial statements regularly – annually or sometimes multiple times a year. This is for the existing investors to keep track of their money.