How to Analyze a Balance Sheet

How to Analyze a Balance Sheet
How to Analyze a Balance Sheet

Senior executives and chief accountants of a company regularly sit down and examine the balance sheet, looking at the numbers to know the financial health of their organization.

They examine the following four components of a balance sheet. 

4 Important Components of a Balance Sheet 

  1. Assets:

    They look at the numbers on the assets side and come to know the resources that are owned by the company. They examine the long-term assets: the buildings, the machines, the land, and the transportation equipment. The numbers tell them what these assets were worth at the start of the year and after deducting for depreciation, what they are worth at the end of the year. In case they have to sell these assets, they will know what they can hope to get for them.
    Then there are the current assets: cash, accounts receivables and prepaid expenses. These assets are the lifeline for the day-to-day operations of the company and the management needs to keep the cash flowing so that the organization will have enough to fulfill demand. The numbers on the assets side need to be large for the executives to feel happy. After all, without resources, how can a company function? In case there is a shortage of assets, the company will have to adopt new methods to improve the situation.

  2. Liabilities:

    On the opposite side of the balance sheet are the company’s liabilities. These are the debts that the company will have to pay: the creditors, the accounts payable, repayments on commercial paper, accrued income taxes from the previous year, and any other accrued liabilities. Apart from these current liabilities, there are long-term liabilities, minority debt, capital leases and any other loan and interest repayments. The numbers need to be ideally within a manageable limit so that the company can use its resources to pay back their creditors.

  3. Equities:

    Equity is the capital that has been invested by the owners of the company and other shareholders. Companies often issue shares in different public offerings at different times. Some companies have all their shares owned by the promoters, while other companies have their shares purchased by large sections of the general public and freely traded in the capital and derivative markets.
    The numbers are split up into preferred stock and common stock, telling the management what the rights of the different shareholders are and what the liabilities of the company will be in the event of winding up. These numbers also tell them how much dividend they will have to pay and what the voting rights of members are during an annual general meeting. Furthermore, they look at the retained earnings so that they know how much investment has been channeled back in the company.

  4. Ratios:

    Ratios are calculations of returns on assets, inventory turnover ratio, quick ratio, total liabilities to net worth etc. These ratios tell the management if the assets are being used profitably, if the company has excess resources that could be put to better use, if current assets are more than current liabilities or vice versa, if the inventory is producing the output that it should and so on and so forth.

The totals on the assets side and the liabilities side will always tally. However, that total figure is not a good enough indicator for balance sheet analysis. Analysis of the balance sheet is always done by comparing current assets and current liabilities, earnings and shareholder’s equity, debtors and creditors, and so on. These numbers also have to be benchmarked with the market average and the balance sheets of other companies. Unless the analysts establish benchmarks, they will never know if the numbers are impressive or not.

There is much that a balance sheet can tell the company. Maintaining an accurate balance sheet is essential to project the correct picture of the business.

Also Read Related Articles:

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3 Important Financial Ratios for a Business

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