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Rick J. Makoujy, Jr., is the author of Accounting in an Hour, a 60-minute interactive DVD and e-learning course that promotes financial literacy to nonfinancial employees. He lives in Woolwich Township, NJ.

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How to READ a Balance Sheet

The McGraw-Hill Companies, Inc.

Contents

Chapter One

WHAT IS A BALANCE SHEET?

The good news is that reading financial statements is easy. Let's start with a short overview of the first of two important financial statements, the balance sheet.

The balance sheet shows what a company's assets are (what it owns), what its liabilities are (what it owes), and what its equity is (what's left over) at a specific point in time.

That's it. Memorize that sentence—it's pretty important. By the way, the specific point in time is usually the end of the year or the end of a quarter. Simplistically, what did I own and what did I owe at the end of last year, and what was the difference between the two?

To start, there are three principal components of a balance sheet. The first, assets, is things that are owned. There are many types of assets. Assets that are readily converted into or used as cash are deemed short term in nature. Examples of short-term, or current, assets are cash, monies due from customers (called "accounts receivable"), inventory (stocked items for sale), or any other owned items that are expected to be liquidated or used as cash within one year from the date on the balance sheet.

Assets such as real estate, furniture, or equipment used to operate the business are generally not expected to be sold within 12 months. Consequently, these owned items are classified as long term in nature. Long-term assets maintain their value over an extended time frame based on their estimated useful lives. A building, for example, will not decline in value as quickly as a computer, and less of its cost is lost each year as a result.

On the other side of the ledger, a company that owns assets typically also owes money to various people or entities in the form of liabilities. Liabilities are simply IOUs. A business or individual might owe money to employees in the form of accrued payroll or vacation time, to vendors (suppliers who have shipped product or provided services with the expectation of payment in 30 or 60 days, called "accounts payable"), to banks in the form of credit cards or other debt, to the Internal Revenue Service, or to other creditors. Those debts that must be paid within a year from the balance sheet's date are considered short-term liabilities. Obligations that needn't be paid for at least 12 months are deemed long-term liabilities.

The difference between assets and liabilities is called "net worth," or equity. In short, if you were to sell the assets shown on a balance sheet at their listed values and use the proceeds to pay off the stated liabilities, whatever is left would be considered equity. Equity is the value the owners have in the business. Similarly, an individual might sell his or her possessions, satisfy all creditors with the proceeds, and keep whatever is left over for himself or herself. Keep in mind that it is possible to have negative equity if the proposed asset sales wouldn't result in enough cash to pay off the listed liabilities.

Let's look at an easy example. Imagine buying a house for $100,000, with a $10,000 down payment and a $90,000 mortgage. You've just created a balance sheet. A $100,000 asset (the house) equals the $90,000 liability (the mortgage) plus $10,000 in equity (also called "net worth"). In other words, if you sell the asset and use the proceeds to pay off the liabilities, you get net worth, or equity.

Of course, companies (and individuals) have assets of varying kinds in addition to real estate. These include cash, inventory, equipment, and patents. We owe money in forms other than mortgages, such as taxes, utility bills, credit cards, and payroll. Net worth, or equity, is calculated by subtracting total liabilities from total assets. It's simple.

PRIMER ON THE INCOME STATEMENT

To fully understand the balance sheet, you need to be familiar with another major financial statement, the income statement (also called the "P&L," or "profit and loss statement"). Here's an overview.

The income statement (P&L) shows how much money a company generates, how much it spends, and what is left over during a period of time.

Easy. By the way, the income statement's period of time is often one year or one calendar quarter. I'll illustrate the income statement through the use of a simple example: Jackie's Hardware Store.

The first component of the income statement is revenue. Revenue is the money an organization receives before paying any expenses. Sales are the portion of revenue that comes from selling products or services to customers, such as retailers getting money for stocked goods, or legal fees paid to an attorney. Other sources of revenue include proceeds from a tenant's rent to a landlord or royalties received by an author from a publisher.

For nonprofit organizations, annual revenue may be referred to as "gross receipts" and may come from donations from individual or corporate donors, fund- raising, membership dues, grants from government agencies, or return on investments. Tax revenue is money that a government receives from taxpayers. In many countries, including the United Kingdom, revenue is called "turnover."

The price of goods or services multiplied by the number of those items sold determines a company's annual revenue. In Jackie's Hardware Store, Jackie receives money from selling products like hammers, saws, and nails to her customers. Let's imagine that she sold 1,000 hammers last year for $10 each. She would have generated $10,000 in hammer revenue. Similarly, she sold 2,000 saws last year for $20 each, creating $40,000 in saw revenue. If we add the total revenue from hammers and saws to the revenue from all of the other products in her store last year, we'll assume that she generated $1 million in total revenue, which in her case comes from sales.

The next piece of the income statement is direct costs. Direct costs are those expenses that are directly correlated with sales. In other words, if Jackie generates zero revenue, theoretically, her direct costs should also be zero. Examples of direct costs are commissions (which are paid only when sales occur) and the cost of the goods that she sells. Jackie does not have any commissioned salespeople in her store, so her only direct costs are from the products that she sells.

It is important to note that the purchase of inventory is not an expense when Jackie buys the goods. This transaction is simply the transfer of one asset, cash, to another asset, inventory. The expense occurs when the value is lost. When the hammer becomes someone else's property and the customer walks out of the store, Jackie's Hardware Store no longer owns it. The value is lost at the time of the sale. The recording of the sale (generation of revenue) occurs simultaneously with the expensing of the inventory even though it was previously purchased.

Last year, as we learned, Jackie sold 1,000 hammers. Her cost per hammer was $5 each, so her direct cost associated with the sale of hammers was $5,000. Her cost per saw was $10 each, so her direct costs for saws last year on the 2,000 that she sold was $20,000. Let's add her direct costs for hammers to her direct costs for saws to all of her other direct costs last year. We'll suppose that she had total direct costs for the year of $500,000. For example:

Direct Costs
Commissioned salespeople $ 0
Cost of good
...