How to interpret a balance sheet

The balance sheet is a financial statement which captures the state of a business at a particular time. It offers a summary of the assets and liabilities of the business as a whole on the day the balance sheet is drawn up. Learning how to interpret a balance sheet is an invaluable skill as it offers insights into the assets of a business and its liabilities. In simple terms the assets are what the business owns or what is owed to it, while liabilities are what the business owes to others. 

Balance sheet interpretation and analysis

The overview offered by a balance sheet shows clearly how the funds coming into the business are used. There are many reasons why a business or organisation needs to create a balance sheet at any time:

• to include it within the annual accounts of a limited company

• to create an accurate picture of the worth of the organisation at that moment, for the use of people such as shareholders, creditors and investors

• to create an internal management tool in order to analyse the current operational status of the business and identify possible improvements and efficiencies

Once created, a balance sheet is used when finances need to be raised or when contracts are being tendered for. The bigger the contract, the more evidence of financial stability the clients need, and, as part of audited accounts, a balance sheet plays a vital role in building a picture of a well-run company.    

Information needed to interpret a balance sheet

To interpret a balance sheet, you need to understand the information included and what that information reveals about the financial well-being of the organisation. The information includes the following:

• Fixed assets – assets owned by the company which will not be sold in the near future. Examples include property, machinery, heavy plant and land. These are the assets used to deliver the goods or services provided by the business and couldn’t be converted into cash quickly and easily.

• Current assets – the assets owned by the company used in the production of goods or delivery of services, up to and including the money used to pay for raw materials. These assets are only part of the business for a short period of time and can easily be converted into cash. Examples include cash carried by the business, stock held and money owed to them by customers (referred to as accounts receivable).  

Liabilities

Balance sheet interpretation and analysis hinges upon the comparison between assets and liabilities. Liabilities are made up of the amounts the business owes, and can be current or long-term. 

• Current liabilities – amounts owed by a business to be paid back within a year. Examples include money owed to suppliers (referred to as accounts payable), short-term loans and taxes. 

• Long term liabilities – amounts owed by a business over the longer term. Examples include mortgages on properties or longer-term bank loans.  

To calculate the net current assets of your business, subtract the current liabilities from the current assets. In addition, the balance sheet shows how liquid the assets of the business are – i.e. how much is held in cash or can easily be converted into cash – how the business is financed and how solvent it is. 

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