Why Reading Balance Sheet is important
I wrote about why accounting is essential for business professionals in our previous blog post: What Is Accounting For Business Professionals. If you are not an Accountant, your goal to learn Accounting is to read financial statements of companies. Reading Balance Sheet is the first step for you to understand the financial statements. Let’s take a look and learn about the tips to reading Balance Sheet.
1.Balance Sheet Structure
First of all, you need to understand the Balance Sheet structure. Balance Sheet consists of three parts, which are Assets, Liability and Equity. When you do business, you are using your Assets in business activities to generate sales and make a profit. The Asset is the things that companies owns. Therefore Assets are cash, account receivables, inventories, machines, land, cars, and securities. Liability is the financial obligations that companies owe to other parties. If you buy something and haven’t paid yet, then that is a debt, which is Liability. Another case is when you loan from banks, your cash increases but at the same time, you owe the bank to return the money you have lent. Equity is the initial funding from shareholders. Just think for now that it is the difference of Asset and Liability.
Asset – Liability = Equity
The asset is the financial property you own. Liability is the minus financial property which you owe to other parties. If you think the structure, Equity is the difference between Asset and Liability which describes the net worth of your financial property.
Take a look at the sample of Balance Sheet.
2.What Liability and Equity means in Balance Sheet
I think most of you will understand Assets quite quickly. Most of the Assets are visible, and you can realise that we used Assets in our day to day business operations. On the other hand, Liability and Equity are hard to imagine, because these are not visible. Some of you might misunderstand that the cash you have loaned from banks are Liability. This is not correct. Cash is an Asset. Liability is the duty for your company to repay your debts back to banks. Same as the Equity when you have a new shareholder funding additional cash, this cash itself is Asset.
Liability and Equity are showing how you sourced your Asset
If you think like this, then it will be easier for you to understand that Asset is on the left and Liability and Equity on the right will always be equal, because it is showing how you gained your Assets. This image helps critical for reading Balance Sheet.
3.What Do Stock and Flow Mean?
I’m sure most of you have heard about Balance Sheet is Stock and Income Statement is Flow. Stock means that you have a value and that balance will exist as long as you continue business. Imagine the Asset. The Assets have value. If you own the Asset itself and do not use them, then the value of your Asset do not change. Financial Accounting has a principle that companies must set the value of the Asset when you acquire them. Therefore is you own a land, then the value of the land in Balance Sheet will remain as the value of purchase amount although the actual value may increase or decrease. Flow means that you are calculating your revenue and expense based on a periodic base. Therefore the sales amount relies on financial period, and you do not accumulate the revenue in Income Statement.
4.Why Cash is the King
When you start your business, the first thing you will do is to fund and secure the cash to run your business operation. Therefore you can also think that we are changing Cash into a different type of Assets. Therefore Cash is the base of Asset, and if you are short in Cash, then you may not be able to convert to other Assets quickly. Cash is also called Liquid Assets, which means that you can easily convert your Cash into other Assets. For example, when you buy a machine or a car it is still an Asset, but it can be difficult to convert those into Cash again. In most cases, if you have used them it may be sold lower than the value in your Balance Sheet. Secure Cash is one of the critical factors for you to continue your business.
5.Why Do We Need to Categorize Current and Fixed/Long-Term?
Most of the Accounting tutorials will explain about Current and Fixed Assets or Long Term Liability. Why do we need to categorise Assets and Liability to current and logn-term? The reason is related to the importance of Cash we mentioned earlier. Current Assets are Assets which can be converted to Cash easier compare to Fixed Assets or Other Assets. Current Liabilities are obligations you have within the year. Therefore if you compare Current Asset and Liability then you understand that how well you can convert your Assets to Cash and secure from short term Liabilities. Most of the Accounting tutorials will just focus on definition and teach you that Current Assets means “Assets that are expected to turn into Cash within a year.” It is correct, but I think business professionals needs to understand “WHY” we need to categorise so that it helps you reading Balance Sheet.
6.Focus on Account Receivables and Account Payables
We recommend business professionals to focus on Account Receivables and Account Payables balance when reading Balance Sheet. First reason is that Account Receivables and Account Payables are critical short-term Assets and Liability which will impact your short-term cash flow. If you have more AR balance, compare to AP balance that means you are paying more compared to collect cash from sales.
The other reason is that Account Receivables and Account Payables require the cross-functional organisation to manage the process of payment and collection. Especially collection is a challenge as it will need Sales and Accounting to cooperate to make sure the collection is completed based on credit terms.
7.Why Inventory Impacts Business
Inventory is another critical Asset for a business operation. We also mentioned about advantages of inventory in our past blog post. Financially optimising inventory is one of the key challenges that CEO’s face especially in manufacturing, retail and trading industries. Inventories are valuable on the other hand can be a risk if those inventories are unable to turn into revenue. If your inventory turnover ratio (Sales / Inventory) is low, then you need to work on reduction of inventory.
8.Debts and Loans
Have you heard the news that Toyota does not have any loans? You have wondered why Toyota has Liability but does not have any loans from banks. As we mentioned earlier, loans from banks are not the only Liability in Balance Sheet. If you want to check the whether the company has loans from banks, then check Debts or Loan Payables on both Current Liabilities and Long-Term Liabilities. There are cases that Debts are classfied as Notes Payables. If the Debt amount is larger than your Cash balance, you might be in a difficult situation in cash flow. This is one way to check whether how much money the companies are borrowing from banks.
9.Asset is Investment and Shows Risk in Business
The Balance Sheet shows the total amount of investment of your business. When you divide the net profit with total Asset, you can analyse the return on investment. As I mentioned earlier, business activity is generating profit by investing Assets. This is the fundamental analysis of return on investment. Total Assets also shows the financial risks of a company. Global top companies such as Siam Cement Group’s ROA is 9.3% (2015) and Toyota’s ROA is 4.9% (2015). If there is 1% of the Asset does not have value, then the financial conditions can impact the business.This is the reason why business owners will try to minimise the entire volume of the Assets.
How was the 9 Tips For Reading Balance Sheet? I hope this helps you to read financial statements and also to be motivated to learn more about the Financial Accounting. After you have learned Balance Sheet, you can move on to learn First 3 Steps For Reading Profit and Loss Statement.