How to Read a Balance Sheet

Every publicly traded company issues a series of financial statements at least on a quarterly basis, and the balance sheet is perhaps the statement most indicative of a company’s financial health.

A company’s balance sheet contains important information about how much money it has, how much it owes, and more. In this article, we’ll discuss the basics of balance sheets, how they work, what to focus on as an investor, and a real-world example of a balance sheet.

How balance sheets work

A balance sheet is a financial statement that shows the current financial state of a business and calculates the book value, or investors’ equity, in the company. There are three main components of a balance sheet — assets, liabilities, and shareholders’ equity.

1. Assets signify what the company owns, such as cash, inventory, property, and other investments.
2. Liabilities represent what the company owes, including loans, accounts payable, and other debts.
3. Shareholders’ Equity is the residual interest in the assets of the company after deducting liabilities, essentially reflecting the company’s net worth.

Balance sheets are important for investors to read because they can answer some very important questions about a company’s financial health and financial flexibility. By knowing how to read a company’s balance sheet, you can find the answers to questions such as these:

• How much cash does the company have available to make acquisitions or invest in growth?
• How much tangible property, such as factories and machinery, does the company own?
• How much debt does the company have?
• What is the actual book value of the company?

The Importance of a Balance Sheet

The significance of a balance sheet cannot be overstated, as it provides a snapshot of a company’s financial condition at a specific point in time. This financial statement is indispensable for several reasons:

1. Financial Analysis and Decision-making: Investors and analysts use balance sheets to assess the financial health and stability of a company, making it an essential tool for investment decisions.

2. Credit Evaluation: Lenders and creditors examine balance sheets to determine a company’s creditworthiness and ability to repay loans, which influences lending decisions.

3. Strategic Planning: Management utilizes balance sheets to identify strengths, weaknesses, and opportunities for improving the company’s financial standing and operational efficiency.

4. Regulatory Compliance: Companies are often required to publish their balance sheets to meet legal and regulatory requirements, ensuring transparency and accountability in financial reporting.

In essence, a balance sheet is more than just a financial document; it’s a comprehensive reflection of a company’s fiscal responsibility, strategic direction, and overall sustainability. Whether for investors assessing the viability of their investment, creditors gauging credit risk, or management strategizing for the future, the balance sheet stands central to informed financial and strategic planning.

The Balance Sheet Formula

Although a balance sheet itself can be quite complex and difficult to understand for many investors, the central concept is rather simple:

Rearranging this equation a bit shows that assets minus liabilities equals shareholders’ equity. Also known as a company’s book value, shareholders’ equity can be thought of as the theoretical amount investors would have if a company closed its doors, sold off its assets, and paid its debts. Obviously, a large company wouldn’t be very likely to do that, but the idea is similar to how home equity works — if your home’s value is more than what you owe the bank, you have positive equity.

Elements of a Balance Sheet

As previously mentioned, there are three main parts of a balance sheet — assets, liabilities, and shareholders’ equity. Let’s take these one at a time.

Assets: The short explanation is that “assets” include everything a company owns. Assets are typically broken down into current and non-current assets. Current assets include liquid assets, such as cash and short-term investments. They also include assets that are expected to become liquid within a year, such as inventory and accounts receivable.

Non-current assets include things that won’t be able to be readily spent within the next year. Tangible property, such as a factory, is the most obvious example, but this also includes equipment, long-term investments, and intellectual property.

Liabilities: Most notably, the liabilities category includes a company’s debts. Like assets, liabilities are separated into current liabilities (those due within a year) and non-current liabilities. Debts coming due soon and accounts payable are examples of current liabilities you’ll typically find on a balance sheet, while long-term debt is the most common type of non-current liability.

Shareholders’ equity: Subtracting the company’s liabilities from its assets shows its shareholders’ equity. The metric itself is most useful when evaluating value investments as opposed to growth stocks since it shows what a business is “worth” simply due to what it owns and owes without any regard to its income-generating or growth potential.

It’s also worth mentioning that shareholders’ equity and a company’s market capitalization (the market value of its stock) are often very different numbers, especially if a company can generate high returns on its assets or is growing rapidly.

Example of a Balance Sheet

Let’s look at a real-world example of a balance sheet and how to read it. Here’s a shot of Shopify‘s (TSX: SHOP) balance sheet as things stood at the end of December 2022:

Assets

Let’s start with the assets section. When you hear that a company “has a lot of cash,” it usually isn’t actually holding all of it in cash. The “cash and equivalents” category on the balance sheet contains actual cash as well as instruments like money market accounts. However, there’s also the “marketable securities” categories in both the current and non-current assets categories that contain things such as Treasury securities, bond investments, and stocks. The key point is that these can typically be readily converted into cash the company can use. So, while Shopify has roughly $1.65 billion in actual cash and equivalents, this figure swells to more than $5.05 billion when considering marketable securities.

Second, it’s essential to realize that, aside from cash and marketable securities, other values listed in the assets section aren’t set in stone. For example, there’s no guarantee that Shopify could sell its property equipment holdings for the $130 million listed. And”other current assets” is the vaguest of them all, which typically includes the value of things such as patents, goodwill, and other difficult-to-value items.

With that in mind, we can see that Shopify has a total of about $6.05 billion in assets on its balance sheet.

Liabilities

The biggest liability on Shopify’s balance sheet is its long-term debt, which stands at about $1.6 billion. It also has a smaller amount of short-term debt, plus about $532.5 million in accounts payable (such as rent or outstanding invoices).

While Shopify has more than $1.6 billion in current and deferred liabilities — and this is certainly a lot of money — the key point to know is that this is a very broad category. On the current side, this can include things such as payroll obligations, accrued benefits, and other items due within a year. On the non-current side, liabilities can include lease obligations, deferred tax credits, customer deposits, and pension obligations, just to name a few.

In all, Shopify has about $2.51 billion in liabilities reported on its balance sheet.

Shareholders’ Equity

When we take Shopify’s assets and subtract its liabilities, we see that its shareholders’ equity is about $8.2 billion. As previously noted, think of this as the amount of money that would theoretically be left if Shopify decided to cease business operations, sell everything it owns, and pay off its debts.

This is not a measure of how much the business is worth. Instead, shareholders’ equity is useful when evaluating value stocks and comparing the valuations of stocks in similar industries. For example, looking at the price-to-book value (P/B) ratio is especially useful when evaluating bank stocks since other common valuation metrics (like the price-to-earnings ratio) aren’t always a great fit.

How to Create a Balance Sheet

If you own a small business or simply want to analyze your personal financial condition, a balance sheet can help you tremendously. You can start by listing your assets, including your cash, investments, accounts receivable (money you’re owed), any inventory you own, property you have, etc. Then, make a list of all of the debts and other obligations you have. You can find some excellent balance sheet templates online that can help to keep you organized. Subtract the liabilities on your balance sheet from the assets to find the equity you have in your business or your personal net worth.

Here’s a step-by-step guide to creating a balance sheet:

1. Title: Start with the title “Balance Sheet”, followed by the company’s name and the specific date the balance sheet represents.

2. Assets: Divide assets into two categories:

• Current Assets: Cash and other assets expected to be converted to cash or used up within one year, like accounts receivable, inventory, and short-term investments.
• Non-current Assets: Long-term investments, property, plant, equipment (PPE), intangible assets, and other assets that are not expected to be converted into cash within one year.

List each asset and its value in respective columns and sum them up to get the total assets.

3. Liabilities: Similar to assets, divide liabilities into:

• Current Liabilities: Obligations due within one year, like accounts payable, short-term debt, and accrued liabilities.
• Non-current Liabilities: Obligations due after one year, including long-term debt, deferred tax liabilities, and pension obligations.

List each liability along with its value and calculate the total liabilities.

4. Shareholders’ Equity: Also known as net assets or net worth, this section reflects the company’s value if all liabilities were paid off. Components include:

• Paid-in Capital: The total value of all sold shares.
• Retained Earnings: Profits reinvested in the company, not distributed to its shareholders.
• Treasury Stock: The cost of shares repurchased by the company.  

 Sum up these figures to obtain the total shareholders’ equity.

5. Balance: Ensure that the equation Assets = Liabilities + Shareholders’ Equity holds true. This fundamental accounting principle implies that a company’s assets are financed either by borrowing money (liabilities) or by using the shareholders’ funds (shareholders’ equity).

6. Format and Presentation: Ensure clarity and conciseness in the layout. Commonly, assets are listed on the left and liabilities plus shareholders’ equity on the right, or assets are at the top with liabilities and equity below. Use a spreadsheet for automatic calculations and a cleaner presentation.