Reading a balance sheet is a skill required in accounting and should be used for serious investors. The three different financial statements are balance sheet, income statement and statement of cash flows. The balance sheet shows a firm’s assets, liabilities, and owners’ equity. For the purpose of this ‘How To’ I’ve used a fake company named Newton Company to better understand how to read a balance sheet.

Steps

1. Learn what assets are. Assets are valuable resources that a firm owns or controls.
2. The simplified balance sheet shown in the example below includes four assets.
   * Cash obviously has value.
   * Accounts receivable are amounts owed to Newton Company by its customers; these have value because they represent future cash inflows.
   * Inventory is merchandise acquired that is to be sold to customers. Newton expects its inventory to be converted into accounts receivable and ultimately into cash.
3. Finally, equipment (perhaps delivery vehicles or showroom furniture) enables Newton to operate its business.
4. Understand what a liability is. Liabilities are obligations of the business to convey something of value in the future. Newton’s balance sheet shows two liabilities.
5. Accounts payable are unwritten promises that arise in the ordinary course of business. An example of this would be Newton purchasing inventory on credit, promising to make payment within a short period of time.
6. Notes payable are more formal, written obligations. Notes payable often arise from borrowing money.
7. Know what the equity is. The final item on the balance sheet is owners’ equity, which refers to the owners’ interest in the business. It is a residual amount that equals assets minus liabilities. The owners have a positive financial interest in the business only if the firm’s assets exceed its obligations.

Tips

• Note that four types of transactions affect owners’ equity; owner contributions, owner withdrawals, revenues and expenses.
• Note the date is usually fiscal period ending or in English the business week/month/year end this way it reflects exactly what the company has at the stated point in time.
• The right side must always equal the left side because assets can either be owned or loaned therefore it will show how much the company owns or owes. Obviously the lower the liabilities and higher assets and owner equity the better!

Warnings

• A big number in the asset column can be a bad thing if they are neck deep in loans.

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