The balance sheet, along with the income statement and the statement of cash flows, is one of the 3 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?
A balance sheet is a breakdown of 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. This necessary balance is why this kind of financial statement is called a “balance sheet.” However, there is a little more to the information on display on a balance sheet.
To start, 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. But 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.
Of course, just reading a long list of numbers can only tell you so much. 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.
Balance sheet vs. income statement vs. cash flow statement
In addition to the balance sheet, the other 2 main financial statements that stakeholders may use are the income statement and the statement of cash flows. Each of these provides different information, so it’s a good idea to look at all 3 to get a more complete picture of how the company is doing.
Here are some basics on these other 2 important financial statements:
Income statement
An income statement can also be called a profit-and-loss (P&L) statement. While a balance sheet provides a snapshot of a company’s financial position at a point in time, an income statement provides information about the company’s income and expenses over a period of time, like a quarter or a year.
The top of an income statement starts with revenue, which essentially means the total dollar value of sales the company completed in the period. Then the income statement subtracts (or for some items adds) various items, such as the costs of goods sold, administrative expenses, interest expense, and taxes. The bottom of the income statement is profits, which can also be called net income. That’s why profits are often called a company’s “bottom line.”
Cash flow statement
The cash flow statement details cash that has flowed in and out of the business over a period of time (again, like a quarter or a year).
Although it might sound like a statement of cash flows covers the same material as an income statement, a company’s profits and its cash inflows can actually look very different. For example, suppose a company makes a sale on credit. That sale would show up as revenue and contribute to profits on the income statement, but might not translate into a cash inflow until a later period.
Cash flow statements generally separate a company’s activities into 3 parts: operating activities, investing activities, and financing activities. The information on the statement of cash flows can help you gain a more complete picture of the company’s finances and business.
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 more 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.
