How To Read And Understand The Balance Sheet?

Many people struggle to understand financial statements because they look complicated at first glance. However, understanding the document doesn’t require expert accounting knowledge. It can be understood with a basic understanding of assets and liabilities.

Evaluating a balance sheet is necessary for business owners to understand the financial health of their business. Whether planning to invest, start a company, manage a service business, or run a retail store, learning how to read a balance sheet can help them make smarter decisions.

Here is a step-by-step process on how to read and understand the balance sheet.

What Is A Balance Sheet?

A balance sheet is the financial statement presenting what a business owns, owes, and what is left for the owners. It gives a picture of a business’s financial position at a specific time. It is called a “Balance Sheet” because everything has to balance out correctly.

Here is the basic formula used by bookkeepers in Melbourne: Assets = Liabilities + Equities. Look at what each of these means.

1. Assets – What a Business Owns

Assets are everything that the business owns or controls that has value. The assets are split into two types:

1. Current Assets: These assets are easily convertible into cash within a year, such as:

• Cash
• Accounts Receivable (money owed by the customers)
• Inventory (products/services the business intends to sell)

1. Non-Convertible (Fixed) Assets: These are the long-term items that the business will utilise in conducting its operations, such as:

• Property (land or buildings)
• Equipments
• Vehicles

The total of these assets will give you an idea of what the business has under its control.

2. Liabilities – What a Business Owes

Liabilities are the debts and obligations of the business. Like assets, liabilities are broken into two categories by expert Melbourne bookkeepers for correct recordkeeping:

1. Current Liabilities: Debts due within one year such as:

• Accounts Payable (money owed to suppliers)
• Short-term loans
• Taxes payable

1. Non-Current Liabilities: Long-term debts such as:

• Bank loans
• Bonds payables
• Lease obligations

Liabilities tell you how much of the business’s finances are found through borrowing.

3. Equity – What’s Left For the Owner

Equity (owners’ or shareholder’s equity) is the difference between assets and liabilities. It represents the owner’s portion in the business.

Equity generally consists of:

• Capital invested by the owners or the shareholders.
• Retained earnings (the profit the business has kept rather than paid out)

This is the portion of the business that truly belongs to the owner.

Why The Balance Sheet Must Balance?

The total value of all the assets is always equal to the liabilities plus equity. Everything the business owes (assets) must have been paid for either with borrowed money (liabilities) or with the owner’s money (equity). If the asset side and the liability side don’t match, then it means there are some errors in the records and accounts of the business.

How to Read the Balance Sheet?

Here is a breakdown of the process into a practical way used by professional bookkeepers in Melbourne for effortless reporting and financial evaluation:

Step 1: Examine the Reporting Date

The date is shown at the very top of the balance sheet. It shows you the time frame for the picture. A balance sheet is not a summary of the business’s financials over an entire year; it is a summary of the financial position as of that day on the reporting date.

For example: If you are a retailer and want to read and understand your balance sheet, then firstly check the dates “As of December 31, 2024,” the balance sheet represents the business at the end of that day.

Step 2: Review the Assets Section

Assets comprise everything that the business owns. They are on the balance sheet’s left side (or the top section). You’ll see assets separated into current and long-term (fixed) assets.  

• Does the business have enough cash or liquid assets?
• Are total current assets more than current liabilities?

Step 3: Review the Liabilities Section

Liabilities represent what the business owes to others — loans, bills or payments due.

They, like assets, break down into current liabilities and non-current liabilities.

What to Look For:

• Are liabilities increasing faster than assets? That could indicate increasing levels of debt.
• Can the business pay its short-term liabilities with its current assets?

Step 4: Examine the Equity Section

Equity is what remains when you subtract liabilities from assets. Equity represents the owners’ claim in the business.

What to Look For:

• Is equity increasing over time? That indicates that the business is building value.
• Are there positive retained earnings? That indicates that the business has made profits in the past.

Step 5:  Financial Ratios for Instant View

Melbourne bookkeepers use a few simple ratios that help provide more context to business assessment.

Current Ratio = Current Assets ÷ Current Liabilities

A healthy business should have a Current Ratio figure above 1 because it needs to be able to cover its short-term liabilities.

Debt-to-Equity Ratio = Total Liabilities ÷ Total Equity

A high figure suggests that the business relies excessively on debt.

Wrapping Up

A balance sheet can look intimidating, but as soon as you know the numbers and what they mean, it can become the most insightful instrument.

It has a story to tell, not in words but in numbers, about how business is run, how healthy it is, and the direction it is headed. So when you look at a balance sheet, begin to read between the lines to make good decisions.