It is important to be able to interpret, or 'read' a balance sheet. To do this you will have to know how it is constructed and what the specific terms mean. Again the real meaning of the balance sheet will not be evident unless compared with previous years' balance sheets.
Book keeping works on a simple idea. Any transaction involves a 'giving' and a 'receiving'. If you spend $1 on an ice-cream, you give $1 and receive a good in return worth $1. If you draw up an account to record this transaction the value of the 'giving' side of the account will equal the 'receiving' side of the account. The balance sheet works on the same principle. It shows where the firm obtains all of its funds (sources) and where these funds went (uses). It must, therefore, balance!
The balance sheet represents a valuation of the firm's assets and liabilities at a particular time. It is a snapshot of the business's wealth.
Assets are anything, tangible or intangible, that is capable of being owned by, or owed to, a business. Assets produce value and have a positive economic value. Assets can be converted into cash (although cash itself is also considered an asset). Tangible assets include current assets and fixed assets.
Examples are land, buildings and stock.
Liabilities are financial obligations, debt or claims on the business. These are anything owed by the business when the balance sheet is prepared. Liabilities can be classified as long-term or current. Examples are mortgages, bank loans and creditors.
We have already discussed in the sources of funds section that there are two sources of funds: equity and debt.
The firm obtains its funds from shareholders (shareholder capital) or borrows them from external organisations such as banks (liabilities). It uses these funds to purchase the factors of production required to produce goods and/or services.
Sources of finance - this explains where the money to fund Net Assets has been sourced including share capital and retained profits.
Below is a sample balance sheet for Student Computers plc which represents the value of the firm's assets and liabilities at the end of the present financial year. The current balance sheet can be compared with the previous year.
Remember, a balance sheet is just a snapshot at a point in time. It is a still picture, which on its own could be misleading or even dangerous. A picture of passengers on the Titanic just before the disaster would have shown many happy and relaxed people, not knowing that the ship was about to hit an iceberg and sink!
Are you able to define the term balance sheet? Write your definition down, and then click on the link to compare your definition with ours'.