The balance sheet, along with the income statement and the statement of cash flows, is one of the primary financial statements used to understand a company’s financial situation. The balance sheet reports the business’s assets, liabilities, and equity, at a point in time. Assets minus liabilities equals shareholder equity, which is one measure of the value of the company to its owners.
Here’s what you need to know about how to read a balance sheet.
What is a balance sheet?
A balance sheet is a financial statement that lets investors and other stakeholders know what the company owns (its assets) and what it owes (its liabilities) at a point in time.
Thinking about your own personal balance sheet can help you understand a company’s balance sheet. Anything you own, like your financial accounts, a car, or a house (if you own one) is an asset. Anything you owe, like student loans, a car loan, or a mortgage is a liability. If you subtract your liabilities from your assets, you get your net worth, which is similar to shareholder equity.
Typically, balance sheets are prepared on a set schedule, such as once a quarter. It is common to refer to a balance sheet as a snapshot of the company’s financial situation since it provides the financial position of the company as of a specific date.
What does a balance sheet show?
All of the items on a balance sheet, which are the assets, liabilities, and shareholder's equity, are used to balance this formula:
Assets = liabilities + shareholder equity
In other words, the amount the company has in assets must be equal to its liabilities plus its shareholder equity. Put another way, a company’s assets minus its liabilities equals its shareholder equity.
Every balance sheet will provide the latest information on assets, liabilities, and shareholder equity as of the reporting date. It will often also provide the same information for a previous reporting date, such as the quarter or year before. This gives stakeholders an opportunity to see how the company’s financial position has changed.
Here’s what those categories mean.
Assets: What the company owns. Assets can be something physical, like a piece of equipment, or it could be something intangible, like a patent. On a balance sheet, assets are often further categorized as either “current assets,” which the company expects to convert to cash within the next year, or “long-term assets,” which the company expects will take more than a year to convert to cash.
Liabilities: What a company owes. This could be a formal “IOU,” like a bond, or something like accounts payable or wages payable. As with assets, liabilities are typically categorized as either “current,” meaning they’re expected to come due within a year, or “long term.”
Equity: Equity is essentially what’s left after you subtract liabilities from assets.
Here are some more specific items that could be included in each category:
| Assets | Liabilities | Shareholder equity |
|---|---|---|
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|
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How to read a balance sheet
Reading a balance sheet can feel confusing at first to new investors. Howver, as you become more familiar with the language of financial statements it may become easier to make sense of them.
Here are some questions and observations to start with as you’re reading a balance sheet:
- How are the numbers stated? For example, companies often present their statements in thousands or millions, to make them easier to read. If a company presents its statements in thousands, then a figure listed on the balance sheet as $800 would really mean $800,000.
- What comparison periods are presented? Look at whether the balance sheet has numbers from the previous quarter or year.
- What has changed between then and now? Look at what categories of assets and liabilities have gone up or down since then. Reading the rest of the company’s statements, like its income statement and statement of cash flows, may help you understand why they have changed.
Financial ratios are another important set of tools in an investor's toolkit. These can help put the numbers on a balance sheet into context, make it easier to compare the financial health of different companies, and see how a company’s health has changed over time.
Here are some examples of financial ratios investors can calculate with the help of the balance sheet:
Current ratio: Current assets / Current liabilities
The current ratio measures a company’s liquidity, or ability to meet its near-term obligations.
Debt ratio: Total liabilities / Total assets
The debt ratio measures a company’s overall level of long-term financial risk.
Financial leverage: Total assets / Total equity
The financial leverage ratio is another way of measuring a company’s overall financial risk, and to what extent it has financed its assets through debt.
Why balance sheets are important
A balance sheet provides critical information about the financial position of a business. An investor can use a balance sheet to help determine the company’s short- and long-term financial health. Investors can also compare a company’s current balance sheet and related financial ratios to its past balance sheets and/or to the ratios of other companies.
What to keep in mind when reading a balance sheet
While a balance sheet can offer a great deal of information to savvy investors, there are still some important things to keep in mind.
To start, make sure you go over the fine print. Balance sheets often include a number of footnotes. These footnotes may simply offer clarification, but at times they may also be a discreet place for the business to share information it does not want to draw attention to.
Additionally, it’s important to contextualize the information you find on a balance sheet. It is simply a snapshot of the company’s financial position at one point in time. To fully understand the company’s financial health, you should also look at the income statement and statement of cash flows. Looking at a company’s past financial statements and comparing them against the statements of competitors or peers in the same industry can help provide further context. Without the full context, you may not completely understand how the company is doing.
Balance sheets and other financial statements are generally included in a company’s quarterly and annual reports to shareholders.