A balance sheet is like a great novel written in a language you don’t speak. It can tell you so many useful things about a company, but when most of us look at terms like “net receivables” and “non-current liabilities,” we feel our eyes starting to glaze over.
The good news is that the jargon is quite easy to decode. In the previous tutorial in this series on financial statements, we looked at how to read an income statement, and discovered that beneath all the surface complexity was a fairly simple story of a company doing business from year to year.
It’s exactly the same thing with a balance sheet. In this tutorial, we’ll help you translate the accountancy language into plain English, so that you can understand the story a business is telling you through its balance sheet.
You’ll start by understanding the purpose of the balance sheet and how it’s structured. Then we’ll go through line by line, breaking it down so that you see how the story is being told.
When you understand how it works, we’ll take what you’ve learned and apply it to a real-world example, Apple’s accounts. Then we’ll look at a few variations you might come across, both in the U.S. and internationally.
By the end of the tutorial, you’ll understand how a balance sheet works and what it tells you about the health of a business. Instead of feeling your eyes glaze over, you’ll be able to read a balance sheet just as easily as you read your favorite novel.
1. How a Balance Sheet Works
As in the previous tutorial, we’ll work with the example of a fictional company, CoolGadget Corp. Here’s a summary of CoolGadget’s balance sheet, which you can also download as a spreadsheet.
OK, what’s your initial reaction?
Unless you’ve got a background in finance or accounting, it’s probably something along the lines of “What the...?” So let’s see what’s going on here.
The point of a balance sheet is to add up everything a company owns—all the money, buildings, equipment and so on—and also to take into account any money it owes in the form of bank loans or other debt. Everything it owns is listed under “assets”, and everything it owes comes under “liabilities.”
If you made your own personal balance sheet, for example, you might have a house, car, savings accounts and retirement fund under “assets”, and a mortgage, auto loan and credit-card debt under “liabilities.”
So where does the balancing part come in? After all, in the personal example, it’s unlikely that your assets will exactly match your liabilities. One or the other will almost always be higher (and we hope for your sake that it’s the assets).
In our example, too, CoolGadget’s assets of $1.5 million are higher than its liabilities of $1.1 million, leaving a difference of $400,000.
For individuals, that difference would simply be chalked up as the person’s net worth, but for companies it works a little differently. Companies all have owners, whether that’s a single person, a handful of people, or millions of stockholders. What’s left of a company’s assets after subtracting its liabilities belongs to the owners.
So in CoolGadget’s case, that $400,000 is listed as stockholder equity. The balance sheet now balances perfectly: the total assets are $1.5 million, and the total liabilities and equity are $1.5 million. In every single balance sheet you look at, you’ll see that same balancing act taking place. It’s a way of making sure that every penny is accounted for.
So that’s a high level view of the balance sheet. Most balance sheets, though, give a lot more detail of how those assets and liabilities are broken up. The details are what help us to understand exactly what story the business is telling. We’ll look at each section in turn, and see what they tell us.
We already know that assets are all the things a company owns. So this section of the balance sheet just shows more detail on exactly what those things are.
The basic breakdown is between “current assets” and “non-current assets.” It’s easy to understand the difference if you think of your personal finances. “Current” would be things you have quick access to, for example the money in your checking account. “Non-current” assets are things you own for the long term but can’t easily sell quickly, like your house.
Ideally you want to see healthy numbers in both sections. CoolGadget, however, has non-current assets of almost $1.4 million, but current assets of just $125,000. That’s worrying, because the company might struggle to pay its bills without selling off long-term assets or taking on more debt. It’s as if you own a house, but have no money in your checking account to pay the utility bill.
Now let’s look at the individual lines.
Cash in accounting doesn’t mean physical bills and coins. It just means money on hand, like the money in your checking account.
Short-term investments are things like stocks and bonds that management intends to sell within a year.
CoolGadget has net receivables of $15,000 because it’s sold some gadgets but hasn’t received the money in its account yet. When the money comes in, it’ll be moved to the “cash” line, but for now it’s recorded here.
CoolGadget has 1,000 gadgets sitting in its warehouse, waiting to be sold and shipped out. Each one is worth $100, so its inventory is $100,000.
“Other” is of course just a convenient bucket for stuff that doesn’t fit anywhere else.
CoolGadget has sunk $450,000 into 10-year bonds and other long-term investments. We like that forward thinking, but it leaves the company worryingly short of current assets.
The company also has a cool office space in downtown San Francisco, decked out with giant flat-screen TVs on every wall, an aquarium and a sauna. Hence the high figure for property, plant and equipment.
Intangible assets sounds like a bit of a vague category, but actually it’s very important, particularly in today’s knowledge-based economy. It measures the value of CoolGadget’s brand, its intellectual property like patents and trademarks, and other non-physical assets.
Other assets: yep, that bucket again.
Here you can see the same breakdown between “current” and “non-current”. In this case, “current liabilities” means money that has to be paid out within a year. Longer-term debt is “non-current”.
This part of the story shows that CoolGadget is in some trouble. Its current liabilities are higher than its current assets, meaning that unless something changes pretty quickly, it will struggle to pay its bills. That’s the kind of story the details of the balance sheet can tell you, and in this case it’s looking as if it won’t have a happy ending.
Again, let’s go through each line.
CoolGadget bought those flatscreen TVs on the company account, and hasn’t paid for them yet. Along with money it owes to suppliers, that makes for an eye-watering $200,000 in accounts payable. Think of this as like a credit-card balance you haven’t paid off.
Accrued expenses are things that you know you’ll have to pay, even if the bill hasn’t come in yet. If you’ve made income and not paid tax on it yet, for example, you’d record the expected tax bill as an accrued expense.
You can probably figure out what long-term debt means. CoolGadget’s is huge, that swanky San Francisco office is probably mortgaged up to the hilt. Now we know where that large interest expense in the income statement came from.
4. Stockholders’ Equity
In this section, CoolGadget accounts for what’s left of the assets after taking out debts and other liabilities.
The company’s founding partners originally put in $350,000 to start the company: that’s the capital stock.
The retained earnings line is where the company’s profits from past years accumulate. We saw in the income statement tutorial that CoolGadget made $8,000 in net income, and you can see that recorded here: the retained earnings rose from $42,000 in 2012 to $50,000 in 2013.
5. The Real World: Apple’s Accounts
So we’ve covered the whole balance sheet: assets, liabilities and stockholders’ equity. Let’s apply what we’ve learned to a real balance sheet: Apple Inc.’s, taken from page 47 of its 2013 annual report.
The layout is the same as in our example, but Apple has included a few different details, recording things that are important for its own business. You can see that Apple reports “deferred revenue,” for example, and “goodwill.” Here’s what they mean:
Deferred revenue is when you receive money in advance for something you haven’t delivered yet. It’s recorded as a liability to show that you still owe the goods to the client.
Goodwill is perhaps the most mysterious item on the balance sheet at first sight. To understand it, forget about any real-life definitions you may have of “good will.” For an accountant, goodwill is something else. If Apple buys another company for $1 billion, for example, but the company’s physical assets were only worth $600 million, the remaining $400 million would be recorded on its balance sheet as goodwill.
Overall, you can see that Apple has a much stronger balance sheet than CoolGadget. Its current assets of $73 billion easily cover its current liabilities, and its overall debt level is quite low. Thanks to the profits it has accumulated over the years from all those Macs, iPods, iPads and iPhones, it has a huge $123 billion in shareholders’ equity. Even if Apple has a few lean years, the company has massive reserves to fall back on.
6. International Variations
For U.S. companies, the basic structure of a balance sheet is always the same, but you’ll often see slight variations in the categories a company chooses to show. We saw several of them with Apple’s balance sheet, and each company may have its own quirks.
With the balance sheets of foreign companies, the biggest difference you’ll notice is that sometimes they balance in a slightly different way. In the UK, for example, companies often subtract liabilities from assets. It’s the same principle as for U.S. balance sheets, just a different way of presenting it. Here’s an example, from British pharmaceutical company GlaxoSmithKline plc (GSK):
But sometimes the international balance sheets look quite familiar, with just a few variations in the order of the lines and the terms they use. Here’s German car manufacturer Volkswagen’s, for example:
As you’ve seen, the balance sheet is a business’s story, just like the income statement. In this tutorial, we’ve given you a dictionary to help you translate that story into plain English. You can now use what you’ve learned to examine any company’s balance sheet, and understand what it’s telling you.
Don’t worry too much about the small variations you come across. Just concentrate on understanding the structure for now. If you want to go deeper into a particular detail, public companies include extensive notes in their annual reports to explain every line of the balance sheet.
As with the income statement, the best thing to do is to practise. You can find balance sheets for any public company on a financial website like Morningstar or Yahoo Finance, or from the Investor Relations section of the company’s website. See what kind of assets a company has, how high its debts are, how much profit it has accumulated. As you do this more often, the terms will become more and more familiar, and you’ll never have that glazed-eye feeling again!
Now that you can read a balance sheet and an income statement, the third piece of the puzzle is the cashflow statement. So stay tuned: we’ll cover that in the next tutorial in the series.