Reading Financial Statements 101: Part 2

Jessica Levine, CPA, CMA Best Practices Leave a Comment

FS101

Now that you have an understanding of the Income Statement (IS), let’s discuss The Balance Sheet (BS).  The Balance Sheet, or ‘Statement of Financial Position’, is a summary of the financial balances of an organization. Simply put, the BS provides an outline of what is owned, and what is owed.

To recap, the IS provides information about a period of time, such as a corporation’s fiscal year (ex.  January 1 to December 31 2019).  The BS provides a ‘snapshot’ of the company at a specific point in time, such as the end of the fiscal year (ex. As at December 31, 2019).  Of the four basic statements, The Balance Sheet is the only one that applies to a point in time.

As its name indicates, the 2 sides of the Balance Sheet must be equal. The Balance Sheet can be summarized by the following equation:

Assets = Liabilities + Equity

Assets

An Asset is any resource owned by an entity that has economic value, or can be controlled to produce value or future benefit. On the Balance Sheet, Asset accounts are listed from top to bottom in order of liquidity, i.e. how easily they can be converted into cash. In that same vein, Assets are classified as either ‘Current Assets’, which can be converted to cash in one year or less or ‘Non-Current (Fixed) Assets’, which can not.  A few examples are listed below:

  • Current Assets:
    • Cash and Cash Equivalents (ex. securities, short-term bonds, etc.)
    • Accounts Receivable
    • Inventory
    • Prepaid Expenses
  • Fixed Assets:
    • Buildings and Equipment
    • Financial Assets (ex. stocks, bonds, etc)
    • Investment Property
    • Intangible Assets (ex. patents, copyrights, goodwill)

Financing

While Assets generally represent resources, the other half of the Balance Sheet equation demonstrates how these resources are financed – either by borrowing money (‘Liabilities’) or by using internal funds (‘Equity’).

Liabilities

A liability is a present obligation of an entity, the settlement of which is expected to result in an outflow of resources. Similarly to Assets, Liabilities are broken down into ‘Current’ and ‘Long-Term’ sub-categories:

  • Current Liabilities :
    • Accounts Payable
    • Wages
    • Taxes
    • Unearned Revenue
  • Long-Term Liabilities
    • Long-term Investments (ex. bonds, notes)
    • Leases/Mortgages
    • Pension Obligations

Equity

The word equity can be likened to ownership and the most common type of equity is known as ‘Shareholder’s Equity’.  Hypothetically, it is the value that would be left over for shareholders if a company utilized all its assets to meet all its liability obligations. By rearranging the Balance Sheet equation above, we get:

Equity = Assets – Liabilities

This demonstrates that Assets, net of any Liabilities, equal Equity.  Put simply: what I have, less what I owe, is what I own.

Types of Equity accounts include:

  • Share Capital (Common Stock)
  • Preferred Stock
  • Stock Options
  • Reserves
  • Retained Earnings

Uses of the Balance Sheet and Financial Ratios

The Balance Sheet, along with the IS and cash flow statements, are an important tool for owners, investors and other shareholders looking to gather information about a company and its financials.

Now that you have a basic understanding of what is in the financial statements, it’s important to know what to do with that data and how to interpret it.  Financial Ratios provide a point of analysis when monitoring a company’s performance.  Though not very useful on their own, ratios become a powerful tool when compared to other companies, industry benchmarks and internal trends over time.  Some of the more commonly know ratios include Return on Investment (ROI), Debt to Equity Ratio, and Price-Earning Ratio.

Ratios can be categorized into 6 main categories based on the type of information they provide as follows:

  1. Liquidity Ratios – measure the ability of a company to pay off short-term debt
  2. Solvency/Leverage Ratios – compare a company’s debt levels to assets, equity and earnings
  3. Profitability Ratios – asses a business’s ability to generate earnings from it’s normal operations
  4. Efficiency/Activity Ratios – evaluates how well a company uses its assets and liabilities (balance sheet accounts) to generate sales and maximize profits
  5. Coverage Ratios – measure a company’s ability to make payments associated with debts
  6. Market Ratios – used to evaluate the current share price

After reviewing the aspects of the Cash Flow Statements, we’ll take a closer look at the above ratios and their relevance in difference industries and circumstances. Many of them are surprisingly easy to calculate, yet provide a lot of information, so get ready to impress your friends at parties with your financial prowess.

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Jessica Levine, CPA, CMA

Jessica is the Manager of Accounting and Financial Services at Redstone Agency. She has experience in a variety of industries and has worked both in the startup world and with a Big 4 firm. She brings with her a wealth of knowledge on accounting and financial management best practices, as well as processes and procedures for ensuring clients’ financial health.

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