Balance Sheet Explained

Balance sheet is an accounting document that indicates the economic and financial situation of a company at a specific time. It is a photograph of the company’s assets, rights and obligations at a specific date.

The balance sheet indicates the good or bad economic health of the company.

It is a document that will help us make future decisions, since it shows the situation of a company at a certain time.

As a financial document that shows the assets, liabilities and net worth of the company at a specific time, the balance sheet tells us what a company has and how it has been financed.

It is very important to emphasize the last detail of the definition: “at a certain moment”.

And it is that if we prepare the balance on December 31 at the end of the financial year of the year, this will show the situation of the company on that day.

Because, the next day, when we make the first sale or purchase, the situation will have already changed.

Therefore, the balance sheet is not valid to see the evolution of the company, but to consult the economic data at a given time (year-end).

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The importance of balance sheets

The balance sheet resembles an x-ray. In this case, it is the x-ray of your company’s skeleton. The balance sheet provides you with information on the structure of assets and liabilities:

  • It indicates the liquidity of the assets, that is, the possibility of converting them into money in the short term (in less than a year);
  • It shows you the quality of the liabilities, that is, the maturity period of your debts and obligations. This can be long-term (more than a year) or short-term (less than a year).

For example, a bad financial situation for your company would be one in which you have many liabilities that expire in the short term and little liquidity in your assets.

Since you cannot easily transform your assets into money in the short term, your company has less money to face the maturity of your short-term debts.

This situation is very common, by the way, in times of economic crisis.

As the balance sheet is a public document that shows your company in the nude, its importance lies, among other things, in attracting potential investors.

Or to dissuade them if your business is in a doubtful state of solvency.

Think that the balance sheet shows the financial muscle of your company to face crisis situations and gives signs of its potential growth in the future.

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How to interpret the balance sheet

To understand a balance sheet, it is essential to break down the structure of assets, liabilities and net worth. In other words, know its different parts:

Assets

Assets can be divided into:

Non-current assets. They are resources with a permanent duration (greater than one year) and not intended for sale.

These are machinery, cars or other company vehicles, computers, patents, land, offices, etc. Also known as fixed assets.

Current assets. They have a short-term duration (less than a year) and are intended for sale.

These are raw materials or merchandise that will be sold or invoiced (stocks), the debts that your clients have with your company (realizable) and the money that your company has in cash and in their bank accounts (available).

They are also known as current assets.

Liabilities

On the part of the liabilities we have a structure traced to the assets:

Current liabilities. These are short-term debts and obligations that your company has: commercial debts as unpaid expenses; wages or taxes not paid to the tax authorities, etc.

Non-current liabilities. They are the debts and obligations that your company has pending in the long term.

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Finally, there is the net worth, which implies:

  • The contributions made by the partners.
  • The benefits and retained earnings of your company.

Having made the clarifications, we can start to “read” the balance sheet of your company:

The working capital

This indicate the amount of resources (assets) that your company has to finance its activity in the short term. It is calculated by subtracting the net equity and the non-current liabilities from the non-current assets.

Working capital = non-current assets – (equity + non-current liabilities)

Three situations can occur:

That the working capital is equal to zero.

In other words, non-current or fixed assets are fully financed in the long term and there is no surplus to finance current assets, which are financed entirely with short-term debts.

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It is not the best situation, because it can create temporary problems of lack of money (or liquidity).

That the working capital is positive.

This means that there is an excess of long-term funds that can be applied to finance the current assets that your company needs to carry out its activity.

If with these funds you manage to finance all your assets, your company will be in a situation of maximum autonomy.

If you finance part of the current assets, then you will be in a stable situation.

If the result is negative, we are wrong.

It means that to finance all your fixed assets you need to borrow in the short term (current liabilities).

And that is not good news, since your company does not generate enough cash flow to pay short-term debts.

There are exceptions: in retail or service distribution companies, where business is more financial than current, it is normal to have a negative working capital.

Well, providers charge later than customers pay.

The working capital is not enough to understand the real situation of your company in the short term.

You can dig deeper by calculating the ratios between different types of assets and liabilities.

In addition to the working capital, it is good to take into account the following general considerations:

Current assets should be greater than current liabilities.

This is a sign that your company does not have short-term liquidity problems.

That you have abundant net worth with respect to the liability.

Well, it is better that the company owes money to its own partners than to third parties.

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