Balance sheet and income statements can reveal a lot about a company, particularly its assets, liabilities, stability, and solvency at a specific moment in time. It is a document for valuing a business worth and highly imperative for someone considering an investment opportunity. However, to make a solid conclusion, you must be able to read balance sheet and income statement and knowing important financial terminologies.
How to read a balance sheet?
The balance sheet contains pertinent information, which gives a general understanding of a company’s solvency and business dealings. Usually, a balance sheet reports three things:
Asset – A list of monetary items owned and controlled by a business. It includes current assets and non-current assets. Current assets are easy to turn into cash within one year, such as cash in hand, prepaid expenses, inventory, marketable securities, account receivables, etc. Non-current assets include items whose face-value or true-value cannot be realized turn into cash within an accounting year, such as real estate, goodwill, patent, intellectual property, equipment, etc.
Liabilities – Liabilities are typically debt the company owes to a supplier, bank, lender, or other providers of goods, services, or loans. Liabilities are on the balance sheet under accounts payable, opposite to the asset section. There are two types of liabilities – current liabilities and non-current liabilities. Current liabilities refer to obligations payable within one year and sometimes include payroll, rent, utilities, account payables, and other accrued expenses. Non-current liabilities are long-term obligations or debts with payments not due until at least a year later. These long-term obligations can include a lease, long–term loans, bonds payable, deferred tax liabilities, and pension provision.
Owner’s equity – also known as the business net worth- displays the owner’s contribution/investment. Owners’ equity generally includes two key elements (a) Capital raised in the form of investment in exchange for some ratio of ownership and (b) Company earning.
Formulas of Balance Sheet Metric
Balance sheet ratios are short formulas you can use to assess your business’s financial health—just by looking at your balance sheet. They provide important insights into your business.
- The most common balance sheet formula is Assets = Liabilities + Owner’s Equity.
- Current ratio = total current assets are divided by total current liabilities. The 2:1 current ratio is considered an excellent level of liquidity.
- Quick ratio = sum of cash balances + accounts receivable divided by total current liabilities. The inventory balances are excluded from this calculation. The acceptable result would be at least 1.5 to 1.
- Working capital = total current assets – total current liabilities. You can use the working capital formula to determine whether or not your business will be able to meet current obligations, like payroll, bills, and loan payments.
- Debt-to-Equity ratio = Total debt (short term + long term) divided by the total amount of equity capital. Debt-to-equity indicates how much equity is available to cover debts.
How to read an income statement?
The income statement, also known as the profit & loss statement, gives an overview of the company’s expenses, source of revenue, overall profit, and loss incurred in a financial year. The income statements help in examining the financial performance more closely, i.e., whether the company is yielding a profit or not.
The income statement analysis starts with revenues. Is the company selling enough to make a profit and meet expenses?
This information helps decide the profit margin on goods & services and further creates a sales mix.
- If total revenue > total expense = this means the business was profitable
- If total revenue < total expenses = this means the company was not profitable
- Gross profit = Revenue – Cost of Goods Sold
Last but not least, an income statement greatly helps determine General & Administrative expenses (G&A). Also known as the overhead cost, G&A is the expenses businesses pay monthly or yearly, such as rent, salaries, office supplies, utilities, etc. The general formula is:
Overhead Rate = Overhead Costs / Income From Sales
For example, let’s say your income from sales is $200000 with spending of $25000 in overhead costs. Hence, your overhead ratio is .125 or 12.5%. The lower the overhead costs, the higher your profit. This data further enables businesses to control certain expenses and adjustments to increase profits.
Importance of a balance sheet and income statement for a business
The balance sheet helps you to see if you have negative equity in the business, which is a sign that you’re either don’t have enough assets or you’re carrying too much debt.
The income statement on the other hand shows you how your expenses compares to your revenues. It also shows you if you have enough cash to make that big equipment purchase.
But you will not know any of these information if you don’t know how to read balance sheet and income statement.
Read balance sheet and income statement – Pretty easy hein!
We hope this article has given you the basic information you need to read balance sheet and income statement as we know there is more to learn from these reports. If you need help with your accounting and tax needs, consider contacting us today.