Term of the Day: Balance Sheet

Innovictor

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The term of the day that we will examine today is the Balance Sheet. The balance sheet in conjunction with the cashflow statement and income statement provides an accurate picture of a company's financial position.

Definition: The balance sheet refers to a financial statement that carries the summary of a company's assets, liabilities and shareholder equity at a given point in time.

Explanation

The balance sheet paints a picture of the value of the company's assets (what the company owns), the company's liability (what the company owes) and the shareholder equity (the amount of money invested by shareholders).

For the balance sheet to be considered balanced, the following formula must be applied:

Assets = Liabilities + Shareholder's Equity

The balance sheet contains two sides (Assets and Liabilities) and the two sides must balance out for the statement to be balanced and to suggest that the company has healthy financials. The balance sheet has two sides (Assets and Liabilities) because everything the company owns can be referred to as Assets while the company is only able to acquire the said assets by borrowing money (Liabilities) or collecting money from its shareholders (shareholder's equity).

A typical balance sheet will have many accounts on both the Assets side and on the Liabilities side of the statement. For instance, the Assets side will contain accounts such as inventory, cash, investments and property among others. The Liabilities side will contain accounts such as long-term debt, accounts payable and obligations under capital leases among others.

Why You Need to Know How to Read a Balance Sheet

The first reason you should be able to read the balance sheet of any company in which you have invested or in which you are planning to invest is that the balance sheet gives you valuable insight into the company's financial health by showing you what the company owns and what it owes as at the date of its preparation.

Secondly, the balance sheet gives you an insight the company's financial stability. If the company has more liability than assets, it might indicate that the company is operating in dangerous waters and you would want to dig deeper before investing in such a company. Likewise, if the company's assets are more than its liabilities, it might suggest that the company is not effectively utilizing resources or worse still, that the company has some shady accounting going on. Either way, you'll want to do more by the way of due diligence.

Thirdly, the balance sheet tells you how the company is able to finance its operating activities. For instance, if the company's liabilities are mostly from debts, it might be said that the company might need to allocate a greater part of its revenue towards servicing debts and paying interests.
 
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