Learning to Read an Accounting Balance Sheet

When you run a business, you often tend to be pretty focused on having the accounting department produce the kind of financial statements that give you the best chance of impressing investors. The financial statement that does the best job in that area is usually the income statement. The poor accounting balance sheet, on the other hand, is a document that remains in the background, uncared for, and barely heard about. And yet, the balance sheet is the financial statement that starts everything off.

Basically, the accounting balance sheet is something that gives you a snapshot of everything about the financial position of a business that you need really know. This double-columned financial statement on the one side, gives you a list of everything that the business owns, what they call its assets, and another list of everything that the business owes outside parties, what they call its liabilities. What is a professional accountant actually see when he sees two lists of stuff set out one next to the other? Once you know how to read a balance sheet, there's so much you will find it can tell you.

When a professional accountant casts an expert eye over the accounting balance sheet, the first things he looks for are clues to the liquidity and solvency of the business. To most people, the two terms are quite interchangeable. The two terms do both refer to how a company is able to deal with money it owes. But there's a difference.

Liquidity in a business is all about how ready it is with cash to deal with immediate obligations. Solvency is how well set up it is to deal with obligations that are spread out over years. When a professional accountant casts an eye over a balance sheet, he tries to look at something called a coverage ratio. That's a figure that tells one about how much a business owes right away as compared how much it has in cash and money coming in right away in the short term. In general, in the short term, a business needs to have twice as much money as it owes. That's what a bank likes to see when a businessman approaches them for a loan. So there's a figure that you need to keep in mind for what you can learn from an accounting balance sheet - it's the current ratio.

A pro can look at a balance sheet and right away see something he calls a common size analysis. Now what is that? Basically, for a common size analysis, you take individual assets or liabilities that the business has and you try to see how that measures up against the total assets or liabilities that the business has. They call this a vertical common size analysis. If you want a horizontal common size analysis, you take the same figure an average it out over three years. It gives you better idea of the direction the company takes over time.