It’s the dreaded task of having to understand the financials. What purpose does it serve? Leave it to the accountants to work it out. The bean counters. Why do I need to understand the numbers?
Whether you like it or not to survive in business today it’s a numbers game. If you don’t understand what the financials are telling you, you’re behind the 8 ball.
So, how do you ever learn to understand what the financial statements are telling you if you’ve never had any formal accounting training or have never bothered to pay attention during that sleepy afternoon lecture back in your University days?
It may all seem like code language to understand what a balance sheet it telling you, but in fact, it’s actually quite simple and powerful at the same time. The key to understanding is a bit of training and some practice at reading them and before you know it, once you’ve been shown the ways, you know what you’re looking for. By understanding just a few of a balance sheets elements, you have already learnt a lot about what accounting is all about.
The balance sheet is really crafted from a simple accounting equation:
ASSETS = LIABILITIES + OWNERS EQUITY
The assets are the current and future benefits to the organisation such as cash, accounts receivable, inventory, prepayments, property plant & equipment & intangibles. The way they affect the accounting equation are that they are what a business has to show for its efforts and increase the net worth of a business. They are basically ranked in order or liquidity or conversion into cash, the most liquid form of an asset. Whilst holding many assets may seem like a good thing, it’s not always a healthy sign for a business to have too many assets, if they are not adequately used to generate a good return on investment. If you think about it, these are the items that the business is investing in, to generate revenue.
The liabilities are the current and future obligations to the organisation such as trade creditors, accruals/provisions, employee entitlements, unearned revenue & loans. These are debts or obligations a business owes to its stakeholders and have a negative impact on a company’s net worth. Whilst too much debt is definitely not a good thing, having a healthy balance of leverage or gearing in a business, can allow a business to grow significantly, compared to if it grew with no help. Within the liabilities section of a business’s balance sheet if a company is funded through debt facilities this is where it will show up.
The owner’s equity section of the balance sheet shows a number of things such as the ownership structure whether it is funded by share capital or the owners personal contribution of funds. What this section also shows is the retained earnings of the business. Retained earnings is a combination of all previous [revenues – expenses = profits / (losses)] from all previous periods plus the current period as well. This is what causes the balance sheet to balance and is the direct link for the profit and loss statement, so that the accounting equation will balance. Having strong equity is a very healthy sign for a business as this indicates that the business has been profitable and has subsequently re-invested in new assets to generate more profit. The owner’s equity balance is the same balance as assets – liabilities or net assets of a business. This is important because if you sold all assets and paid back all liabilities this is what you would have left for the owners of the business.
So, that’s it in a nutshell. It’s not as complicated as you may think. It just requires a bit of practice and with more experience you will feel more confident every time you pick up a balance sheet. Already just knowing the basic concepts you can tell the liquidity or solvency of a business, you can understand the ownership structure of what is funded through debt vs equity and you can determine what the business is worth on the books. Whilst this may only seem like a few things, it actually tells you a heck of a lot about the business regardless of what industry or sector it is in.
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