The balance sheet – Why is it good to understand?
A balance sheet is one of the types of accounts, alongside the profit and loss account, that give you an insight into the situation of a business.
Businesses need assets to operate. Not necessarily a lot, and not necessarily only in cash terms, but they still need wealth. And this wealth is ‘produced’ from something. The source from which they have done so affects their riskiness and profitability.
You don’t need to be a chief accountant to extract valuable information from the balance sheet. It is sufficient to know the basics to prepare your decision. Different companies’ balance sheets may differ either in the accounting standard used or in the way they are broken down, but unless you are an accountant, you do not need to know them at a deeper level. It is enough to know what it is about, in other words, to be able to read it.
What is common to company accounts anywhere in the world:
- These are fully public (both at home and abroad)
- They include rounded amounts (in Hungary they are rounded to thousands of forints)
- Shows the position of the company at the date of the balance sheet (e.g. 31 December)
Not to be over-mystified, this does not only work for businesses. It works the same way for a family budget, but obviously on a smaller scale. There it is not a question of how big and what you have the factory building and the fleet, but whether you have a house and a car, and if so, how you bought it.
What is the accounting balance?
A balance sheet is a document that
- includes assets and liabilities: these are shown in appropriate depth
- shows the position of the business at a given date: although it relates to the balance sheet date, it also shows the effects of the current year that have not yet been achieved
- all liabilities and assets are valued in accordance with accounting principles
- shows values are expressed in monetary terms (in Hungary also in forint) and are rounded
Where can you access a company’s balance sheet?
For foreign companies, sites dealing with shares are a good starting point. These include macrotrends.net and tradingeconomics.com. For foreign companies, you usually look for companies whose shares or bonds you want to buy. In other words, where you want to invest. Since you are not the only one looking at them with an investor’s eye, in many cases you will also find this information on the website of the company you have chosen.
What is a balance sheet for?
It is nothing more than the assets of the business at a given point in time. By looking at them chronologically, you can get an idea of how the business is developing. This is particularly useful if you:
- own your own business and want to track its progress
- are an investor looking for a place to put your money where it is likely to be well managed
- are looking to take out a bank loan, as this is the basis on which they judge whether to give you a loan and if so, how much
Structure of the balance sheet
You’ve probably seen a plain apothecary scale before, you’ve seen that it has two pans. In one they put the sample to be weighed and in the other they put the weight.
The accounting balance sheet is exactly the same two-sided balance sheet. Here, one of the “pans” is the assets the company has for production. In the other, it is from what it has produced, in other words, what its sources are. The two sides must therefore equal.
Very creatively, the page showing the assets is called the asset side, the side showing the sources of those assets is called the liabilities side.
If you are familiar with Kiyosaki’s work on the division of assets and liabilities, there the asset is what makes money and the liability is what takes money. Well, not here. The asset is what you produce with (you can still produce losses) and the liability is from what you bought the asset.
The asset side of the balance sheet shows what assets a business has. These assets can be:
- physical assets: machinery, raw materials, vehicles
- non-physical assets: e.g. a company buys some rights
- cash: cash in hand, money in a bank account, securities
The liabilities side shows how you bought these assets. You may have money from, for example:
- capital provided by the owner
- profits made in previous years
- some kind of borrowed money: a bank loan, money from investors, etc.
Breakdown of the balance sheet
You can also see the two pages when you look at the balance sheet prepared by the required breakdown (here simplified to the extreme, and this may vary from country to country a little bit).
|A. Fixed assets||D. Equity|
|I. Intangible assets||E. Provisions|
|II. Tangible fixed assets||F. Liabilities|
|III. Financial fixed assets||I. Subordinated liabilities|
|B. Current assets||II. Long-term liabilities|
|I. Inventories||III. Current libailities|
|II. Accounts receivable||G. Accruals and deferred income|
|IV. Cash and cash equivalents|
|C. Accrued income and prepaid expenses|
|Total assets||Total liabilities|
The balance sheet, because it also classifies items according to their intended use, gives you the opportunity to gain a sufficiently in-depth understanding of the management of the business. You can do this by analysing the balance sheet. For guidance on what you can achieve, see the bottom of this article.
Now let’s go back to the shortened form. In the normal scale, you will see various symbols (letters, Roman and Arabic numerals) on both sides of the scale. The meaning of these is what we’ll look at below in expanded form:
- Letters: main groups
- Roman numerals: groups
- Arabic numerals: balance sheet items
The asset side
Here you can see 3 main groups:
- Fixed assets: assets used to run the business for more than 1 year
- Current assets: Assets used to run the business for less than 1 year
- Accruals and deferred income: Items improving the result for the current year
Here you will find 4 main categories:
- Equity: Freely disposable capital that the owners have made available for the use of the company without any time limit (this includes the profit earned on this). In the event of liquidation of the company, this amount is distributed among the owners
- Provisions: A liability that you only know will arise but whose due date is not known at the time the balance sheet is drawn up.
- Liabilities: the company’s payment obligations, grouped by maturity (this section also includes who the company owes, why and how much)
- Accruals and deferred income: items that affect the result for the current year
What can you gain from knowing the balance sheet if you are an investor?
Knowing the opportunities and threats in a company is important as an investor. Without it, you can choose from portfolios put together by investment funds. You also need to have a deeper insight into the life of a company to get a better result (higher returns). You can then reduce the risk of your investment by not making random choices and by buying the right type of shares in the right sector for you.
What can you achieve if you own your own business?
As a shareholder, you become an owner in a company, after a certain level you can have an impact on the life of the company. Then, as it’s your own invested capital, you need to know where the company is going and adjust its direction if necessary. But this is not only true if you have bought shares in a public company from outside. You invest time, energy and money even if you are the founder yourself. And you can be an owner not only of public limited companies, but also of smaller ones, even family or sole proprietorships.
If we are talking about your own business, it is crucial that you can read what your accountant puts in front of you with an understanding. After all, this is feedback on your work. By reviewing the balance sheet, you can get an idea of your own business and therefore of possible directions for improvement. The information you get from the balance sheet, especially by comparing several years, a professional could write a long book about it, so without being exhaustive, here are just a few examples of the benefits of knowing the contents at least at a basic level (even if you can’t compile them).
Know your company’s liquidity. This is either in cash-flow planning or in a business planning exercise, as it is easy to come up with a SWOT analysis or to pay more attention to the topic because of a lot of late payments. But it may also turn out that the problem is the other way round, i.e. too much capital for which you have not found a place. This is effectively dead capital (since it is not working).
If you are getting a far higher return on a single investment than on hours of hard work every day, either change your working practices or invest in someone else’s company.
Profitability indicators based on the balance sheet will help you to judge how part or all of the company is performing.
Optimising the capital structure
This sounds more complicated than it actually is. The capital structure indicators make it even easier for you. You will then see that it doesn’t take much, although it is not always easy to implement.
Capital always has some cost. This varies depending on where the money comes from:
- the owners expect dividends
- creditors (banks, bond buyers) receive interest
And the costs of these have to be generated. By knowing the capital structure, you also get an idea of how much you are still creditworthy (i.e. how much risk is taken by whoever is lending to you).
Among other things, being able to read (and understand) the balance sheet will help you to understand and use the above ratios more easily.