CLARITY How to Read a Balance

How to
a Balance
CA Services for Your Business
A Chartered Accountant’s signature is
synonymous with objectivity, reliability, and
credibility. CAs are proven financial experts.
The CA’s signature on an audit report means
the CA has examined an organization’s books
and has expressed an informed opinion on
the fairness of the financial information.
It’s important to know that not all financial
statements are audited. Many small businesses
don’t need an audit. Whether a CA is required
to perform an audit or simply a review, those
who read financial statements and the
accompanying communications should note
the accountant’s professional status.
Readers can expect the highest standards
of competency and professionalism from a
Chartered Accountant. CAs are proven
financial and management experts, and
business advisors.
Balance Sheets
The balance sheet is a key part
of a company’s financial statements, but it alone doesn’t offer a complete
picture. The complete picture comes from looking at all aspects of the financial
statements, including the balance sheet; income statement; statement of cash
flows; notes; and management’s discussion and analysis (MD&A). Usually
financial statements are produced one to four months after the end of the
financial period, so bear in mind that this information is historical.
The financial statements indicate how a company is being managed, whether
it is profitable, and if it can become or continue to be profitable. You need the
information found in financial statements to calculate the key ratios that will
allow you to make informed investment decisions.
The balance sheet is a snapshot of the company’s assets, liabilities, and equity
at a given point in time. In a nutshell, the balance sheet tells you what a
company owes and what it owns.
Reading a balance sheet may seem confusing at first, but understanding all
of the terms will remove the mystery and allow you to begin evaluating a
company’s health.
When you look at a balance sheet, you’ll notice that assets are listed on one
side and liabilities and shareholder equity are listed on the other. This basic
format is used for all balance sheets. That’s why it’s called a balance sheet—
because it balances.
Assets - Liabilities = Equity
Key Parts of a Balance Sheet
are anything a company owns or is owed.
Current assets
are the most liquid of assets and can be easily converted into cash in a short
amount of time (usually less than one year). Current assets include cash,
marketable securities, receivables, inventory, and prepaid expenses. They are
valued at the lesser of their current value or their original cost.
Property, plant, and equipment
are items the company uses to produce its product or service. They’re listed
separately from current assets because the company does not intend for them to
be sold. They are generally valued at their original cost, rather than their current
value. Property, plant, and equipment assets are long-term and are depreciated
each year based on their original cost.
Other assets
account for items that don’t fit into either of the above categories. Often these
include capitalized leases and interest, deferred charges, and intangible assets
(items that generally can’t be sold and used to pay debts, but that still have
value to the company).
are debts the company owes.
Current liabilities
are debts that will be paid off in one year or less, and are incurred in the
day-to-day running of a company’s operations. These include accounts payable
to suppliers, demand loans, and taxes payable.
Long-term debt
is what a company usually incurs to purchase long-term assets such as a premises
or equipment. This usually comes in the form of bank loans, mortgages,
debentures, or promissory notes. Long-term debt also differs from current
debt because it is due sometime in the future, but not in the current year.
Shareholder equity
is the final item on the balance sheet and consists of the company’s assets
minus its liabilities. Shareholder’s equity shows how much value shareholders
have in the company. Shareholder’s equity is only noted for companies that
issue shares. In organizations without share capital, shareholder equity is
simply referred to as equity.
Sample balance sheet
XYZ Company ($ millions)
Current assets
$ 2.1
Property, plant, and equipment
Other assets
$ 5.2
Total assets
Current liabilities
$ 5.3
Long-term debt
Shareholder equity
Total liabilities and shareholder equity
You might also find commitments and contingencies noted on the balance
sheet without a dollar value. These represent liabilities that will or might be
incurred by the company in the future. This is important information for
investors who are trying to assess a company’s future viability.
Analysing the Balance Sheet
By analysing the balance sheet you can assess a company’s liquidity, how
much its leveraged, its return on investment, and more.
The balance sheet can answer questions like:
• Is the company solid? Can it pay its bills today and in the future?
• Is it making the kind of returns it should?
• What kind of return can you expect from investing in this company?
To get answers to these questions you need to calculate ratios. When you’re deciding
to invest in a company or assessing a company’s health, determining these ratios can
be very helpful. But don’t just calculate them for one year—get data from previous
years and compare your findings. These comparisons will help you determine if the
company is consistent, growing, or declining. And don’t forget to compare the
company with others in the same industry. This will help you measure the company’s
success more accurately.
The liquidity of a company is how much in readily realisable assets the company has on
hand after paying its current liabilities. Performing this calculation is a good way to figure
out whether or not the company will be able to cover its short-term obligations. The way to
figure this out is to look at the company’s current ratio:
Current ratio =
Current assets
Current liabilities
To make sense of the current ratio you must compare it to the ratios of other companies in
the same industry. If the ratio is lower than the average, the company may be having liquidity
problems. But you don’t want the ratio to be much higher than the average either, because this
could mean the company isn’t using its liquidity to grow. Generally a company with a ratio of
1.5 or better is in good shape from a liquidity standpoint.
Another important factor to examine is how “leveraged” the company is—in other words,
how much debt does it have?
Leverage ratio =
Long-term debt
Shareholder’s equity
The higher the leverage number the more risky the company’s situation. You can’t expect a
company to have no debt, but too much debt puts a company at risk for bankruptcy.
Return on Investment
Return on investment (ROI) = Net income
Shareholder’s equity
Return on investment measures how much money the company is making for investors.
High-growth companies will have high ROI values. If the ROI value is 10%, that means that
for every dollar invested the company is making $0.10 in new assets.
Bringing it all Together
As you can see, the balance sheet
contains a great deal of valuable
information and can give you tools
to better understand a company’s
financial situation. But remember:
don’t just read the balance sheet.
Review the other parts of a company’s
financial statements and perform
additional analyses to make truly
informed investment decisions.
For more information on financial
statements and help making financial
decisions, contact your local
Chartered Accountant.
The Institute of Chartered Accountants
of British Columbia is the self-regulating
professional body for all Chartered
Accountants in the province. One of the
Institute’s prime mandates is to protect the
public interest. As members of the Institute,
Chartered Accountants adhere to a strictly
enforced code of conduct and ongoing
professional development. The CA designation
is your assurance of credible and expert
financial, business, and management
advisory services.
For more information on Chartered Accountants
or for a free referral to a Chartered Accountant
in your area, call 604-681-3264 in the Lower
Mainland or toll free at 1-800-663-2677.