A Step-by-step Guide To Understanding & Reading Balance Sheets

Accounting Jul 08, 2020

A balance sheet is like a performance report of any company. It gives you an accurate picture of how your company has performed for the given duration.

When made and balanced right, a balance sheet will reveal your best assets and your most significant liabilities. It will help you identify the key money-making areas for your business, and show you areas that are leaking funds. The balance sheet is one of 3 core components of every business along with the income statement and the cash flow statement.

Pen and calculator kept on top of a balance sheet
The balance sheet is one of 3 core components of every business along with the income statement and the cash flow statement.‌‌

Index

  • Key Components of a Balance Sheet
  • The Golden Equation
  • The Balancing Act
  • Understanding the Balance Sheet

Key Components of a Balance Sheet
Assets:

Assets include everything that a business owns and can be divided into two sub-categories: current assets and long-term assets.All the income falls under these two assets

Money bags| assets
All the income falls under these two assets‌‌: Current assets and Long Term assets

Liabilities:
Liabilities include everything that an organization owes to outsiders. While liabilities are expenditure on the business itself, they can serve as a key tool in saving the business owners' funds. Just like Assets, Liabilities get divided into current liabilities and long-term liabilities.

There are several different criteria under each of those sub-categories. We will discuss them as we move forward.

Man Knocks down the word tower of Debt with a bundle of dollars
Liabilities include everything that an organization/business owes to outsiders. 



Liabilities include everything that an organization/business owes to outsiders. While liabilities are expenditure on the business itself, they can serve as a key tool in saving the business owners' funds. Just like Assets, Liabilities get divided into current liabilities and long-term liabilities.

There are several different criteria under each of those sub-categories. We will discuss them as we move forward.

Equity:

Equity is the total sum of business that the owner brings to the business. Equity usually takes the form of two main components- Paid-up Capital and Retained earnings. Paid-up capital has subdivisions of its own. Retained earnings, basically are funds that the owner has reinvested in his business instead of taking dividends from it, and keeping it from himself.

Equity in the balance sheet
Equity is the total sum of business that the owner brings to the business.


Basics of the balance sheet

Here we have listed three components to help beginners understand the basics of the balance sheet. There are, still, multiple other components that can be understood later, once we get acquainted with making and understanding balance sheets.  

The Golden Equation

To understand balance sheets, we just have to remember one equation.

Assets = Liabilities + Equity

This equation shows us how the key components of account balancing work with one another.

If we were to bring Liabilities on one side, the same equation would read as

Liabilities = Assets - Equity

Similarly, if were to keep Equity on one side, the same equation would read as

Equity = Assets - Liabilities

Simple balance sheet template with assets and liabilities
Simple balance sheet template with assets and liabilities


The Balancing Act

Now that we've understood the core components and their relationship to each other, we can better understand the process.The objective of a balance sheet is to balance. The assets of the business should always be equal to the addition of liabilities and Equity.It is like any other equation. If the left-hand side doesn't equal the right-hand side, you've probably gone wrong in some fashion.

Here are some things that usually go wrong while creating balance sheets.

  • Misplaced/Incomplete data
  • Incorrectly entered transactions
  • Currency exchange rate errors
  • Inventory errors
  • Miscalculated equity calculations
  • Miscalculated loan amortization or depreciation

Understanding the Balance Sheet

Here is how you start making a basic balance sheet for your business. Even though the process is mostly automated now, being able to read it, helps a businessperson understand how his business works on a day-to-day basis. Understanding balance sheets can help them spot potential errors and even gauge future opportunities beforehand.

Step 1: The Reporting Date and Period

A balance sheet depicts the total assets, liabilities, and equity of a company on a specific date, typically referred to as the reporting date. Often, the reporting date will be the final day of the reporting period.
Balance sheets depict the total assets, liabilities, and Equity of a particular company on a set date, called the reporting date. The reporting date comes at the end of the reporting period. Every company decides its reporting period, although most companies will opt for the quarterly reporting period, meaning that balance sheets get created at the end of every quarter. This is the case because the finance sector and share market track their progress based every quarter.

Some organizations will also choose to opt for a yearly reporting period. This usually happens in smaller organizations, since the total number of transactions are fewer, and hence don't need to be reported in a quarterly fashion.Most companies will follow the below-mentioned reporting dates

Q1: March 31

Q2: June 30

Q3: September 30

Q4: December 31

These dates are not a compulsion, but rather a norm that the industry cumulatively follows. Balance sheets are usually made a few days or weeks after the reporting date has passed, depending on the number of transactions on both sides.

Step 2: Identify Your Assets
Once you've decided upon the reporting date, you have to start taking stock of your assets Balance sheets list assets in two ways -

1) Individual line items 2) Total assets.

This will make it easier for the viewer to identify what your assets are and where they are coming from; Both these pieces of information will be required during the final analysis.

Assets are usually split into the following line items:
Current Assets:

  • Cash and cash equivalents
  • Short-term marketable securities
  • Accounts receivable
  • Inventory
  • Other current assets

Non-current Assets:

  • Long-term marketable securities
  • Property
  • Goodwill
  • Intangible assets
  • Other noncurrent assets

Both current as well as non-current assets need to be first subtotaled, and then totaled together at the end.

Step 3: Identify Your Liabilities

Once you are done with identifying assets, you will need to identify your liabilities. These have to be organized too, into both line items and totals, as below:

Current Liabilities:

  • Accounts payable
  • Accrued expenses
  • Deferred revenue
  • Commercial paper
  • Current portion of long-term debt
  • Other Current Liabilities

Non-current Liabilities:

  • Deferred revenue (non-current)
  • Long-term lease obligations
  • Long-term debt
  • Other non-current liabilities

*Like with assets, current and non-current liabilities should be both subtotaled and then totaled together.

Step 4: Calculate Equity

Equity usually depends on the size of the business, or rather on the number of shareholders involved in it. If the organization is private and is held by a single owner or two co-owners, then the equity calculation is pretty straightforward.
If it's a publicly held company, the equity calculation can get a lot more complex, depending upon, how many shares have been issued, and in how many different types.Common line items found in the equity section of the balance sheet include:

Total Equity

  • Common stock
  • Preferred stock
  • Treasury stock
  • Retained earnings

Step 5: Add Total Liabilities to Total Equity and then compare to Assets

For a balance sheet to be correctly balanced, it will be necessary for the total sum of assets to be equal to the total liabilities plus Equity. To do this, you'll need to add liabilities and Equity together.

If the balance sheet does not satisfy the equation Assets = Liabilities + Equity, then you have to go back to recheck the data you've entered. Assets included in liabilities by error, or Equity counted in assets, are major reasons why balance sheets sometimes don't end up equating.

Check all your entries till you find the error and rectify it. Keep doing this until the sheet balances.

Balance sheets are the most basic and most important part of financial reporting and accounting. Balance sheets help you understand the current health of your organization and help you identify problems and discover opportunities.

Balance sheets are the most basic and most important part of financial reporting and accounting. Balance sheets help you understand the current health of your organization and help you identify problems and discover opportunities.There are many tools in the market like Deskera, Tally and Quickbooks that will allow you to maintain balance sheets digitally.

A special mention should be given to Deskera because it is an application designed to be ‘always-on’ for all your business and accounting needs. It is highly appreciated by today’s mobile workforce. This application’s ‘One Solution for your Business’ approach makes it an all-in-one solution for not just your balance sheets but for various requirements of accounting as well as invoicing. Deskera is highly sophisticated and flexible at the same time. With a single sign-on authentication-feature, it lets you switch between various parameters of your business such as accounting, finance, operations, inventory, HR, etc. It should be noted that its intuitive dashboard lets you seamlessly observe all your business functions in a quick glance and lets you track key metrics that affect your business the most.


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