How to Read a Balance Sheet: The Bottom Line on What You Need to Know about Cash Flow, Assets, Debt, Equity, Profit...and How It all Comes Together

How to Read a Balance Sheet: The Bottom Line on What You Need to Know about Cash Flow, Assets, Debt, Equity, Profit...and How It all Comes Together

Put the most valuable business tool to work for you! The balance sheet is the key to everything--from efficient business operation to accurate assessment of a company’s worth. It’s a critical business resource--but do you know how to read it? How to Read a BalanceSheet breaks down the subject into easy-to-understand components. If you're a business owner or manager, this book helps you . . . Manage working capital - Generate higher returns on assets - Maximize your inventory dollars - Evaluate investment opportunities If you're an investor, this book helps you . . . Determine the market value of a company's assets and operations - Predict future earnings and trends - Assess the impact of capital expenditures - Identify potential "red flags" before the crowd How to Read a Balance Sheet gives you the bottom line of what you need to know about: Cash Flow * Assets * Debt * Equity * Profit and how it all comes together. Rick J. Makoujy, Jr. , is the author of Accounting in an Hour , a 60-minute interactive DVD and e-learning course that promotes financial literacy to nonfinancial employees. He lives in Woolwich Township, NJ. Rick J. Makoujy, Jr. , is the author of Accounting in an Hour , a 60-minute interactive DVD and e-learning course that promotes financial literacy to nonfinancial employees. He lives in Woolwich Township, NJ. How to READ a Balance Sheet By Rick J. Makoujy, Jr. The McGraw-Hill Companies, Inc. Copyright © 2010 The McGraw-Hill Companies, Inc. All right reserved. ISBN: 978-0-07-170033-7 Contents Chapter One PRIMER ON THE BALANCE SHEET AND INCOME STATEMENT WHAT IS A BALANCE SHEET? The good news is that reading financial statements is easy. Let's start with a short overview of the first of two important financial statements, the balance sheet. The balance sheet shows what a company's assets are (what it owns), what its liabilities are (what it owes), and what its equity is (what's left over) at a specific point in time. That's it. Memorize that sentence—it's pretty important. By the way, the specific point in time is usually the end of the year or the end of a quarter. Simplistically, what did I own and what did I owe at the end of last year, and what was the difference between the two? To start, there are three principal components of a balance sheet. The first, assets, is things that are owned. There are many types of assets. Assets that are readily converted into or used as cash are deemed short term in nature. Examples of short-term, or current, assets are cash, monies due from customers (called "accounts receivable"), inventory (stocked items for sale), or any other owned items that are expected to be liquidated or used as cash within one year from the date on the balance sheet. Assets such as real estate, furniture, or equipment used to operate the business are generally not expected to be sold within 12 months. Consequently, these owned items are classified as long term in nature. Long-term assets maintain their value over an extended time frame based on their estimated useful lives. A building, for example, will not decline in value as quickly as a computer, and less of its cost is lost each year as a result. On the other side of the ledger, a company that owns assets typically also owes money to various people or entities in the form of liabilities. Liabilities are simply IOUs. A business or individual might owe money to employees in the form of accrued payroll or vacation time, to vendors (suppliers who have shipped product or provided services with the expectation of payment in 30 or 60 days, called "accounts payable"), to banks in the form of credit cards or other debt, to the Internal Revenue Service, or to other creditors. Those debts that must be paid within a year from the balance sheet's date are considered short-term liabilities. Obligations that needn't be paid for at least 12 months are deemed long-term liabilities. The difference between assets and liabilities is called "net worth," or equity. In short, if you were to sell the assets shown on a balance sheet at their listed values and use the proceeds to pay off the stated liabilities, whatever is left would be considered equity. Equity is the value the owners have in the business. Similarly, an individual might sell his or her possessions, satisfy all creditors with the proceeds, and keep whatever is left over for himself or herself. Keep in mind that it is possible to have negative equity if the proposed asset sales wouldn't result in enough cash to pay off the listed liabilities. Let's look at an easy example. Imagine buying a house for $100,000, with a $10,000 down payment and a $90,000 mortgage. You've just created a balance sheet. A $100,000 asset (the house) equals the $90,000 liability (the mortgage) plus $10,000 in equity (also called "net worth"). In other words, if you sell the asset and use the proceeds to pay off the liabilities, you get net worth, or equity.