Accounting is the language of business, but unfortunately, it’s confusing almost to the point of mystifying to the layperson. A company’s balance sheet is one of the most important financial statements, yet many people don’t understand the “how” and “why” behind its purpose and structure.
The purpose of the balance sheet is simple, it is merely a summary, at a point in time, of what a company owns [assets], owes [liabilities] and net worth [equity]. Why is it organized in such a weird way where the total Assets equals the total of Liabilities plus Equity? Wouldn’t it make more sense to have your Assets less your Liabilities equal your Equity? Accounting is based on the key concept of double entry bookkeeping in which debits have to equal credits. This key principle of balancing debits and credits hews well to the concept of a balance sheet and makes perfect sense to an accounting professional.
The asset and liability portions of the balance sheet are organized between current and non- current sections. Anything in the current section is something that will impact cash in 12 months or less. For example, accounts receivable is considered a current asset as it should be collected as cash within 12 months. Conversely accounts payable is considered a current liability as the amount will be paid to the vendor out of the company’s cash balance within the next 12 months.
The essence of the balance sheet is highlighting the working capital of a company. Working capital is merely taking the company’s current assets and subtracting the current liabilities. The concept of working capital is evaluating if an organization has enough liquid assets to cover debts coming due in the next twelve months. If there is significant working capital, this is indicative of a company being able to meet all near-term obligations along with providing funding for investments in their business or possibly returning funds to owners. If working capital is negative it means the company owes more than they can pay over the next twelve months and the organization will need to seek other financing sources or else the viability of the company may be at risk.
Non-current assets and liabilities provides a view of the longer-term resources and debts of a company. A layperson should take note of the amount of property, plant and equipment that a company owns and is this a business with a lot of asset investments that may require significant upkeep in the future. Additionally, pay careful attention to the long-term debt of the company that will be due in future years therefore possibly putting significant pressure on the organization in the future.
There are a lot of ratios and other indicators that financial professionals use when evaluating a company’s balance sheet, but most of the time its as simple as making sure what a company owns is more than what is owes and ensuring the organization has the liquidity in the short term to pay their debts coming due. It really does not need to be much more complicated than that.