When making an investment in a business, it’s essential to understand that you’re becoming a part-owner of that business. Whenever you make an investment, you weigh up the chances of the business in question returning a greater sum of capital than you originally invested. I was recently asked how I go about weight up this decision. The truth is that there are a complex set of criteria I examine when making an investment; one of which is an examination of the latest balance sheet for the business.
The ability to read a balance sheet is instrumental in understanding the business’s financial position and provides a ‘snapshot’ of the business’s financial health. Being a snapshot, it can change dramatically as time passes, so understanding the perspective of the report and its contents will help you to be better informed when reviewing a company’s financial health.
So what is a balance sheet? It is considered one of the five basic financial reports of any company. In reality, most people can only interpret the two most fundamental reports, the Profit and Loss (P&L) and the Balance Sheet. The Balance Sheet basically identified where the money has come from, and where is it located. The best way to explain this is to illustrate a basic transaction. Let’s start out with the first day of business. On the first day, you as the owner purchased the stock and/or made a capital contribution, normally in cash and so the balance sheet will display the following:
It is important to note that the balance sheet is like a scale, on one side sits assets of some sort (where the money is located) whether physical in nature or intangible like buying a patent or a copyright. All of these categories combined are referred to as Total Assets. On the other side sits two major groupings of where the money was sourced. You could borrow the money which is referred to as a liability or you could have contributed the money which is referred to as Capital. Both liabilities and capital are added together to create Total Liabilities and Capital.
Obviously, this is an extremely simple version of a balance sheet, but business isn’t that simple. So let’s complicate this a bit. Let’s say that the next day, you decide to buy a new laptop to use in the business operation and see how this affects the Balance Sheet.
Let’s assume that you contributed £1000 to the company on day 1, and on day 2, you buy a laptop for £800. Because you’re cautious about how the capital is spent, you didn’t want to give up all that cash for a single laptop, so you decided to borrow £650 to pay part of the bill.
For assets, you now have £850 in cash (the original £1000 less the £150 put towards the purchase of the laptop) and a laptop worth £800. You have total assets of £1650. On the other side of the Balance Sheet, you know have a liability of £650 (the amount borrowed to buy the laptop) and the £1000 you originally invested into the company or the capital. So now the balance sheet looks like this:
Notice how the two sides of the balance sheet equal each other. This is the primary tenet of a balance sheet, if you read one and the two sides do not equal, then something is wrong.
The balance sheet is divided into three major sections for Assets and two major sections for Liabilities and Capital. Below is a description of each of the major areas and in the next article on this subject, I’ll aim to get into some details about reading and understanding these sections.
Current Assets – this section generally includes cash and what we refer to as cash equivalents which include receivables from customers, inventory you purchase to resell, or raw materials you buy to turn into products. This section also includes short term loans you make to others including employees and prepaid items for future services or materials.
Fixed Assets – this is generally high-cost items such as heavy equipment, vehicles, office equipment, storage units or items you buy that will be around for a long time and that you’ll use on a daily basis.
Non-Current Assets – these become more common as the company grows and prospers. They include deposits made or held for long-term contracts (like the utility deposit or rent deposit); goodwill, or the start-up costs you incurred to launch the business.
Liabilities and Capital:
Liabilities – these are debts to various parties. They include suppliers and other vendors and they are referred to as Accounts Payable. You also include credit card debt (the company’s credit card(s)) and short-term liabilities such as temporary notes, taxes owed, or payroll items. Other types of liabilities include long-term. These include notes we use to purchase long-term assets such as fixed assets. Both of these combined make up Liabilities which is one major section of one side of the balance sheet.
Capital – this comprises the invested amounts plus any earnings or losses incurred to date.
Learning to read and understand a balance sheet is instrumental in evaluating a business operation. By understanding the simple format as explained above, you are on your way to learning more complex aspects of reading and understanding the balance sheet. In future articles I’ll have a closer look at each of the respective areas and how to grasp what they really mean.