In this video, we’re going to teach you how to read and analyze a balance sheet.
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A Balance sheet is one of the most important documents you’ll ever encounter as a business owner or investor.
What is a Balance Sheet? A Balance Sheet is a part of the financial statement that reports the company’s assets, liabilities, and shareholders’ equity. The balance Sheet is one of the three core parts to look for in a financial statement, with the other two being the Income Statement and the Cash Flow statement.
By understanding a balance sheet, you can get a better understanding of a company’s financial status and make informed decisions about your investment.
A balance sheet reports the company’s assets, Liabilities and shareholder equity.
It gives investors a very strong insight in the company’s financial position, what the company owns and what it owes.
Balance sheets are separated into three main sectors: Assets / Liabilities/ and Shareholder Equity.
Every balance sheet starts with the total assets, which basically reveals the value of everything the company owns and can be liquidated into cash within 12 months time, that can be inventory, accounts receivable, equipment, copyrights , patents and obviously cash on hand.
Liabilities on the other hand are the legal debts a company owes to third party creditors, these can be employee salaries, mortgage payments, loan payments, sales taxes and so on.
Last, we find the equity or shareholders equity which is basically what the company is worth after the company is liquidated and all the debts are paid off. Thus the shareholders equity equals Assets minus Liabilities.
Now that we have analyzed the three basic components of a balance sheet, let me say that for a healthy and strong company financially, the investors want to see that shareholders equity is always positive, that means that the company has more assets than liabilities. There are exceptions but best you stick with the companies that have a positive equity.
To note here that another term used for shareholders equity is book of value.
Now that we covered the three main categories on the balance sheet, let’s dive a bit more into it and check the subcategories.
Starting with the Assets they are separated into two subcategories the current assets and the non current assets.
Current assets refers to all the assets of a company that can be liquidated to cash easily or are expected to be sold, consumed, or used through business operations within 12 months or a year. Examples of current assets are cash, stocks, inventory, accounts receivable and so on.
And if you expand the total current assets you will see that cash, short term investments, accounts receivables and inventory is indeed there.
Non Current assets on the other hand refers to the assets that the company owes but it does not plan to sell, consume or liquidate in other means over the next 12 months or a year timeframe. These are long term investments, Property Plant & Equipment as well as the intangible assets.
I would like to expand a bit more in these assets and especially on Goodwill as it is associated with the purchase of one company by another. That means that a company can grow its goodwill value by purchasing other companies.
For example, let’s assume Amazon wants to buy a ABC company that is valued at 10 billion dollars but it pays 12 billion dollars for it, that means that amazon overpaid 2 billion to acquire the ABC company, that 2 billion will be added to the goodwill on the balance sheet.
One main point to keep from this section is that since goodwill is basically a company overpaying for another company, for many investors it’s not considered as a real asset and that goes for the entire intangible assets as they are consisted of assets like company’s brand name, solid customer base, good customer relations, good employee relations, and proprietary technology.
You can’t really liquidate those but they still have value, I mean think about Apple products, the value of the brand name and the customer base there is insane.
Anyhow that concludes our closer look into the assets subcategories, let’s turn our attention to the Liabilities. Once more we have current and non current liabilities as well.
Like the current assets, current liabilities refer to the company’s debts or obligations that have to be paid within 12 months or a year. As we can see on the balance sheet examples of current liabilities are short term debt, account payables, Dividends, income taxes and so on. Again current liabilities is the money that the company will have to pay over the next 12 months.
The non current liabilities is the company’s long term debts, that will need to be paid but it is not within the next 12 months, examples of long term debt are long term loans, long term lease obligations, pension benefits, deferred tax liabilities and so on.
In most cases checking the total assets and total liabilities is a good start and good enough for some people, however it is a good practice to dig a bit more, I especially like to check where the majority of total liabilities come from, is it from current or non current liabilities.
Because if a company has a high amount of long term debt and their total assets are not in that great shape, how would the company be able to pay back its debts? And they will have to pay them back in one way or another so In that case an investment to that company wouldn’t be such a good idea.
To note here that now that we talked about the intangible assets and goodwill, it is a good practice to remove them when you calculate the Shareholders equity, this will give you a much better , or as I like to see it a much clearer view on the financials of the company.
Now that you have a much better understanding of the balance sheet, let’s focus on the key metrics you want to look at in order to determine if this company is in a good standing or in trouble.
Companies get loans, hire more people, acquire land and so on to expand, so once more as long as the tangible shareholders equity grows over time the increase of liabilities is not an issue.
The second point of focus is to check the current ratio, to do so we have to compare the total current assets with the total current liabilities. To do that we divide the total current assets with the total current liabilities.
Current ratio is important as it measures the company’s ability to pay its obligations within the span of 12 months or a year. You always want to see a number above 1 here,which means that currently the company has more current assets than current liabilities. In general the higher the number is the better the company stands.
Current ratio is a very important metric for the financial health of each company and you should always pay attention to it.
A third point of focus is to check if over the years certain total cash and total current assets are growing.
In this video, we will teach you how to read and analyze a balance sheet and help you understand the basic information contained in this document.
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