If you are running a business or looking to buy a business, then understanding and interpreting financial statements is essential.
(article continues below)
This is the introductory article to the Balance Sheet Analysis series.
After reading the series, you should gain a basic understanding on how to interpret some important components of the balance sheet.
Before we dig into the balance sheet, let us review the three attributes of financial statements:
- Tax Orientation - Businesses tend to minimize taxes by minimizing the reporting of profits (by minimizing the reporting of income and maximizing the reporting of expenditure). As a result, statements tend to be tax oriented.
- Conservative - An important accounting convention is conservatism. This means when an accountant is unsure which value to use, they will use the most conservative. As a result, financial statements tend to be biased towards conservatism.
- Historical Valuations - Financial statements tend to be historical in nature. This means some assets may be quoted at a historical value instead of current market value.
The balance sheet is one of the four main financial statements: balance sheet, income statement, statement of retained earnings, and statement of cash flow.
The balance sheet reports the company's assets, liabilities, and owner's equity at a given point of time. The balance sheet, as its name suggests, always balances out: assets = liability + owner's equity (ALOE).
When you look at a balance sheet, you will see a list of assets, liabilities, and their associated numbers. As an entrepreneur, you will need to be able to interpret these numbers. To get a general feeling for an All-American balance sheet, the following is a list of assets and liabilities as shown in Berkshire Hathaway's 2007 annual report:
Berkshire Hathaway Assets
- Cash and equivalents
- Accounts and notes receivable
- Other current assets
- Goodwill and other intangibles
- Fixed assets
- Other assets
Berkshire Hathaway Liabilities
- Notes payable
- Other current liabilities
- Deferred liabilities
- Term debt and others
There are many important reasons why you should analyze the balance sheet. Here are a few examples of what you should be looking for in a balance sheet:
- As the owner (or potential owner) of a company, you do not have priority claim against the assets of a company. You want to know if the company could meet its debt obligations and if there is any danger of bankruptcy.
- Is the company in danger of facing a potential liquidity crisis? If the company is unable to meet current debt obligations (aka having a liquidity crisis) then you might have to sell important, illiquid assets at fire-sale prices.
- Will the company have trouble raising new capital?
- How operationally efficient is the business?
- How much should I pay for these assets and liabilities?
With practice, you'll soon be able to look at a balance sheet and immediately get a sense for how a company is doing and what troubles lie ahead. Master that art and you'll have a big advantage over most entrepreneurs.
Learn More About Interpreting a Balance Sheet
To learn how to read a balance sheet and understand what a balance sheet says about how a company is doing, read the other articles in the Balance Sheet Interpretation Series: