How to Properly Read and Analyze a Balance Sheet Without Falling Asleep

October 14, 2015 / Reading: 4 minutes

A Balance Sheet, combined with the cash flow statement and income statement, these three statements make up the bulk of a company’s financial reports. As a result, understanding how to read and analyze a balance sheet is very important to understanding the financial health of your business.

A balance sheet, also know as a ‘statement of financial position,’ details a small business’ assets, liabilities, and the owner’s equity. It also acts as a “snapshot” of your business’ financial position at any given time; which is why it is very important to have a good understanding of what it is and what it can be used for.

What Exactly Is a Balance Sheet?

In essence, a balance sheet is a tool to help your business decide what means are available to keep the business profitable. The balance sheet is the only financial statement in the multitude of commonly used financial reports that actually relates to your company’s financial condition at one specific point in time and can advise you if your business is profitable. A majority of other statements track your business’s financial health over a set period of time.

The primary concept behind a balance sheet is that total assets must equal the liabilities and equity of the business at a specific time (Assets = Liabilities + Owner’s Equity). When describing assets, it is important to note the distinction of how each respective asset was financed. If money was borrowed to purchase an asset, it is a liability. If the owner’s money was used to by an asset, it is considered equity.

Let’s Dig Deeper

To better understand the balance sheet equation, it is important to refresh what types of items get categorized as assets, liabilities, or equity. Assets are typically accounts for things such as inventory, stock, money owed to the business, land, cash, pre-paid insurance, equipment, and buildings.

The primary concept behind a balance sheet is that total assets must equal the liabilities and equity of the business at a specific time

Liabilities are things such as accounts for wages owed to the company’s workers that have not been paid, money owed by the business to suppliers, income taxes, interest on loans, and any other accrued expenses that have not been paid. It is good practice to begin delineating between short-term and long-term liabilities on the balance sheet to better assist with analyzing where the majority of your liabilities are incurred.

Finally, the equity section shows the net assets of capital and reserves the company has on hand. This is the result of taking the total amount of assets and subtracting the total amount of liabilities. The net result is your owner’s equity.

Example of a Balance Sheet

To quickly analyze a hypothetical balance sheet, let’s say that Bob owns a one-man lawn cutting company that has just ended their second year in business and is in the process of calculating their yearly balance sheet. His first year balance sheet had $60,000 in assets, $55,000 in liabilities from long-term debt on equipment purchases, and $5,000 in equity. Applying the balance sheet equation, Bob’s assets equal his liabilities plus assets ($60,000 = $55,000 + $5,000).

After preparing his second year balance sheet, Bob currently has $65,000 in assets, $55,000 in liabilities, and $10,000 in equity. Based on this, his assets again equal his liabilities plus equity ($65,000 = $55,000 + $10,000).

However, the second year balance sheet indicates a $5,000 shift in Bob’s assets and equity. Without looking at line-item specifics, it is clear that Bob has found a way to increase his equity by $5,000 in his second year in business. This could be the result of individual capital infusion, increased revenues, contribution of equipment bought with owner’s cash, or a combination of these factors. Either way, analyzing the differences between Bob’s first and second year balance sheets can give him a quick indicator of how well his business is performing and help him plan for further increasing his business’s profitability in the future.