The balance sheet of a company is their statement of financial position, which is part of the documents needed to assess the financial situation of a company. Why would you need to do that? Analyzing the financial situation of a company comes in handy if you want to weigh your options whether it makes sense to invest in it or not.
In this article, we’ll discuss the basics of how to read a company’s balance sheet, what each section means and how you can use the acquired data in your investment decision. Let’s go!
What is a balance sheet?
The balance sheet is a document that basically states how much the company is worth. It does so by listing up and doing calculations of the following parts:
- Owner’s equity
It’s important to note that the balance sheet is a snapshot of the company’s finances, as the data is all taken from a specific date, the reporting date.
The balance sheet can be used internally by the company’s executives or employees to gain insight if the company is successful with what it does or is failing. On the other hand, it can also be used by external parties like interested investors to see if an investment in the company is sensible or not.
The balance sheet equation
The information under the banner of these three topics form an equation, which is usually depicted as follows:
- Assets = Liabilities + Owner’s Equity
However, there are also two other ways to look at it:
- Liabilities = Assets – Owner’s Equity
- Owner’s Equity = Assets – Liabilities
A balance sheet should, as the name implies, always balance. This means that when the first equation is true, the other two equations have to be true as well. If they aren’t, then there are mistakes in the creation of the balance sheet, for example due to missing or incomplete data.
Assets are defined by what is owned by the company and hold a quantifiable value, and is used by the company to operate its business. Assets are then further split up between current assets (assets that are turned into cash easily, and will be converted within a year) and non-current assets (long-term investments that won’t be converted to cash soon).
Part of the current assets is usually cash and also cash equivalents. The latter are safe assets that can easily be converted into cash, such as bonds of countries like Germany.
Then we have inventory, which is the company’s materials, things in production and also the finished goods. How this is made up depends on the company.
Another part of the current assets are the accounts receivable, which is money owed to the company by its clients. If the company sells products on credit, then the payment for this goes into this section until paid off.
Non-current assets are usually longer term and tangible, like buildings or land, but also intangible, such as copyrights or patents. The reputation of a brand is also part of the non-current assets because it plays an important role in providing value to the company.
On the opposing side, we have liabilities. These are obligations that the company owes to another party, and just like assets, they can be short-term or long-term (current or non-current).
The same definition that is used for current assets, which will be turned into money within a year, apply to liabilities. Current liabilities are everything that will be due within a year. This includes:
- Account payables
- Rent and utility
- Debt financing
- Other expenses
Non-current refers to all the liabilities that won’t have to be paid within one year. One example you can find in many balance sheets are bonds, which have a maturity date of several years. But also longer-term leases and loans or tax liabilities count into this section.
This one is simple. Owner’s equity, sometimes also called shareholders’ equity, is what belongs to the owner of the business after any liabilities. So just like in our equation above, you take the assets of the company, subtract the liabilities and are left with the owner’s equity. It is often the money that has been invested in the business in the beginning.
However, there are two parts to owner’s equity:
- The money that has been invested in the business and for which ownership has been given (usually depicted by shares)
- The generated earnings that aren’t spent and kept in the business
Analyzing a Balance Sheet with Ratios
Once you know what the data in the balance sheet means, you can then use commonly used ratios to see whether the company’s specifics are desirable to invest in or not. One of these ratios is the debt-to-equity ratio, also known as D/E.
The D/E is calculated by dividing the total liabilities (the debt) by the total owner’s equity. Let’s take a look at Creditstar’s annual report from 2021 (one of Lendermarket’s loan originators), in which we can also find the balance sheet.
You can see that the total liabilities come out to 160 610 000 EUR.
The total equity is 38 154 000 EUR.
Now, to get the D/E, you use the following formula:
- 160 610 000 EUR / 38 154 000 EUR = 4,21
Note, that every business is different and to analyze a business not only the balance sheet is important, but also the income sheet and other financial documents. It is worth mentioning that D/E should be compared to similar companies’ D/E ratios.
Taking a look at the balance sheet of a company can provide some insight into how the company is doing financially. It can be worthwhile not only for investors, but also for people inside the company to see whether the business is on the right track or not.
Yet, don’t rely on this as your only factor in decision-making. There are many more things to take into consideration, like the cash flow of the company, where the sector is heading in general, what recent events happened and so forth.
Nevertheless, we hope now you can take a look at the balance sheet and roughly know what’s going on.