How To Read A Balance Sheet
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You’ll see this is the quickest way to check a company’s financial health.
The most common accounting question is how to read a balance sheet. In this article we’ll explain what it means and how to use it, especially when buying or selling an eCommerce business.
What is a balance sheet?
The balance sheet is an accounting document that owners and investors analyze before making decisions.
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Stated simply, it’s a snapshot of a company’s financial picture at a given moment in time.
It shows which assets the company controls or owns.
This document is prepared monthly or quarterly for most companies, and it’s especially important for pre-sale disclosure when buying or selling a business.
Financial snapshot of a single day
Keep in mind that, unlike an income statement which shows revenue during a period of time, the balance sheet only shows a company’s financial health at a single point in time.
Tangible assets can be liquidated quickly and easily.
So, if you’re thinking about buying a business, make sure to check for proof of assets and ownership before handing over any cash.
You should ask a prospective seller for bank statements (with names visible but account numbers blacked out) showing current figures to match cash amounts in the balance sheet.
Also check the corporate name as registered online with state authorities to confirm the seller’s ownership or legal representation of the business being sold.
How to calculate the balance sheet equation
- Assets
- Liabilities(sometimes called “outside liabilities”)
- Owner’s equity (or net assets)
A balance sheet shows two sections. Assets are listed in one section, with liabilities and owner’s equity listed together in the other section.
By now you’ve figured out that the word “balance” means both sections must add up to the same totals.
The equation is very simple:
Assets = Liabilities + Owner’s Equity
or
Assets – Liabilities = Owner’s Equity
Here’s a graphic showing another way of looking at the same concept:
If assets are liquidated to pay off liabilities, what’s left is the owner’s equity, if any.
So how does the balance sheet show us whether a business is thriving or failing?
It’s easy – By comparing the current copy to a previous balance sheet, you’ll immediately see whether the numbers are rising or falling.
Let’s look at assets and liabilities first, since they’re the key to understanding a company’s current situation.
Then we’ll dive into what “owner’s equity” means, especially when you’re buying or selling a business.
Assets
A balance sheet shows which assets the company owns or controls.
If you’re buying a business, it’s especially important to understand the true underlying value of each asset listed on the sheet.
Assets are often described as tangible or intangible.
Tangible assets
These are physical objects that you can see and touch.
They’re generally easy to liquidate at a discount to their original purchase price.
- Cash
- Vehicles
- Equipment
- Inventory
- Land
- Securities like stocks & bonds
Intangible assets
These assets are things which aren’t physical. This includes intellectual property and accounts receivable which represent money you expect to receive in the future.
- Patents, trademarks & copyrights
- Goodwill
- Brand
- Accounts receivable
- Franchise rights
When you’re skimming through a balance sheet, note whether the majority of the business’ value is based on tangible or intangible assets.
Intangible assets are more difficult to evaluate because their future benefits are less certain than tangible assets.
That’s why it’s usually harder to liquidate intangible than tangible assets when the company is facing financial pressure.
eReptile
Here’s an example to illustrate the difference between tangible and intangible assets.
Let’s say you’re an entrepreneur who’s also a reptile enthusiast.
So, you start up eReptile LLC. It’s an eCommerce company to sell snakes and lizards online through the power of digital marketing.
If your company owns a vehicle for the purpose of transporting reptiles, it’s considered a tangible asset.
Also, let’s assume you’ve signed a lizard-supply contract with Hawk Haven.
It’s a fast-growing chain of bird-of-prey sanctuaries with big lizard-eating populations.
Of course, all the live reptiles that you currently have in your warehouse are considered tangible assets.
However, any lizards that you’ve already shipped to their doom with picky hawks – but for which you haven’t yet received payment – are intangible assets listed as accounts receivable (AR) on the balance sheet.
AR is considered a valuable asset because you could sell unpaid lizard-supply invoices at a discount in exchange for commercial credit (factoring) at the bank.
Liabilities
A liability represents a debt owed by the company.
This includes credit card balances, accounts payable and other commercial debts, a real estate mortgage, or any other financial obligation.
At eReptile the ho-hum liabilities include bills from food suppliers for the crickets and mice eaten by your snakes and lizards.
eReptile LLC Balance Sheet
8/30/2019
Assets
Cash $120,000
Accounts receivable
Hawk Haven 38,000
Inventory
Snakes 73,000
Lizards 19,000
Vehicles
Delivery truck 26,000
Total assets $276,000
Liabilities
Accounts payable
Food for snakes 3,000
Food for lizards 2,000
Credit card debt 50,000
Total liabilities $55,000
Owner’s equity $221,000
Total liabilities & owner’s equity $276,000
Assets are owned or controlled, liabilities are owed
An asset is what the company owns or controls, while a liability is what it owes.
It’s important to understand that an asset is anything valuable that your company can benefit from, regardless of its form or who owns it.
In contrast, a liability is a debt, regardless of who actually owns the underlying asset that led to that debt.
That means if something valuable is controlled by a company, it’s still considered an asset even if the business doesn’t actually own it outright.
Snakes in the house
Here’s a simple real estate example to illustrate the relationship between assets and liabilities.
Let’s say you launch eReptile in your apartment without telling the landlord.
The business grows so rapidly that you lose track of some inventory.
The landlord evicts you after finding venomous snakes in the house.
So you go to a herp-friendly banker, and your company gets a loan to buy a warehouse.
The purchase price of the new eReptile warehouse is $300,000.
You make a down payment of $90,000 and get a commercial mortgage for the balance of $210,000.
Regardless of the bank’s lien, the warehouse is considered an asset to the business because you control it.
According to the accounting test, anything tangible or intangible that benefits a business can be considered an asset as long as you control it.
Remember the rented apartment where you first launched eReptile?
You were evicted because it didn’t pass that test: Although your business benefited from using the apartment, it wasn’t considered an asset because you didn’t control the building.
Meanwhile, the bank’s loan is a liability on your company’s balance sheet.
Here’s what the balance sheet looks like –
eReptile LLC Balance Sheet
9/30/2019
Assets
Cash $30,000
Accounts receivable
Hawk Haven 38,000
Inventory
Snakes 73,000
Lizards 19,000
Vehicles
Delivery truck 26,000
Warehouse 300,000
Total assets $486,000
Liabilities
Accounts payable
Food for snakes 3,000
Food for lizards 2,000
Credit card debt 50,000
Loan for warehouse 210,000
Total liabilities $265,000
Owner’s equity $221,000
Total liabilities & owner’s equity $486,000
The asset column shows the value of the warehouse as $300,000 regardless of who owns it.
The amount still owed to the bank is $210,000, which appears in the liabilities column.
After taking the $90,000 down payment from your cash, it’s still reflected in the owner’s equity.
Owner’s equity
Now it’s time to take a closer look at how to analyze the owner’s equity shown in a balance sheet.
As an entrepreneur, owner’s equity refers to the portion of company assets owned by you. It’s like your net cash-out value from shutting down a successful business.
For example, let’s say your new girlfriend is afraid of snakes.
Forced to choose between her and your scaly friends, you decide to shut down eReptile.
After selling all the animals and other assets for cash, and paying off all the bills and other liabilities, the remaining cash would be your “owner’s equity.”
What “owner’s equity” means when buying a business
Keep in mind that owner’s equity isn’t the same as the agreed contract price when a business is sold.
Successful eCommerce companies are typically sold for a multiple of at least 3x their annual sales.
The actual sale price of the business probably includes “goodwill” value as well as an additional premium, plus any broker’s commissions.
Buyer beware – The value of owner’s equity may be inflated by accounting tricks.
What does it mean if the seller’s asking price is much higher than the amount of owner’s equity implied by clearly-identifiable assets on the balance sheet?
It suggests that the business is being offered for sale at a premium price that probably includes lots of additional “padding” beyond the company’s true value.
Book value without goodwill
But when a distressed business is liquidated, its inventory, equipment, real estate and other assets are often sold piecemeal at low prices, which is their “book value.”
For buyers, the best bargains are in distressed businesses with prices close to the book value of assets, and little if any owner’s equity.
Premium price for a successful company
On the other hand, let’s say you’re the seller instead of the buyer.
If you sell a business to an eager buyer at a premium price, you’ll receive plenty of goodwill value.
That’s because there’s more goodwill value in an ongoing business than the book value of those assets liquidated piecemeal.
Goodwill is simply the value of having an already-established brand with existing customers.
For a thriving business sold to an eager buyer, the sale price will contain plenty of goodwill value.
More goodwill means more owner’s equity
Here’s an example: Let’s say that within a couple of years after you launch eReptile, the government enacts strict new legislation that requires expensive licensing for all new dealers in the reptile marketplace.
No new dealer can buy or sell reptiles without applying for a costly license.
But you don’t need licensing: Thanks to a powerful reptile lobby, existing businesses such as eReptile enjoy a “grandfather” exception to the new law.
Since it’s very difficult for new dealers to become licensed, eReptile enjoys a competitive advantage.
Its corporate assets become more valuable because of increasing goodwill and less competition.
When assets become more valuable, the value of owner’s equity also rises, as long as liabilities stay the same.
eReptile might become an attractive takeover candidate for bigger players in the reptile marketplace.
When selling the company to an eager buyer, you can ask for a high multiple of annual sales.
This will be equivalent to a premium value, more than just the amount of owner’s equity shown on the balance sheet.
New wheels
OK, since your eReptile business seems to be going well, you’ve decided to buy another vehicle.
You’ll use it for making sales visits to pet shops, picking up reptile supplies, taking customer order packages to the airport, and impressing your new girlfriend.
You’re lucky enough to get 100% financing to buy a sparkling new Mercedes roadster for only $90,000 including snakeskin upholstery.
Let’s look at an example of how the balance sheet handles non-appreciating assets like cars
eReptile LLC Balance Sheet
10/31/2019
Assets
Cash $30,000
Accounts receivable
Hawk Haven 38,000
Inventory
Snakes 73,000
Lizards 19,000
Vehicles
Delivery truck 26,000
Mercedes 90,000
Warehouse 300,000
Total assets $576,000
Liabilities
Accounts payable
Food for snakes 3,000
Food for lizards 2,000
Credit card debt 50,000
Loan for warehouse 210,000
Loan for Mercedes 90,000
Total liabilities $355,000
Owner’s equity $221,000
Total liabilities & owner’s equity $576,000
First let’s figure out the asset section of the balance sheet.
Since this vehicle meets the accounting test (it helps your business and you control it), it’s definitely an asset.
The car is valued at $90,000, so this amount is added to the asset column.
But that leaves the sheet “unbalanced,” so we need to fix it by adding the $90,000 debt to the liabilities column.
That represents the amount of your car loan from the bank, which is certainly a liability.
Notice that the assets have increased by ,000, but the amount of equity held by the business owner remains unchanged at 1,000.
That’s because the exact same amount is also a debt, thanks to the magic of 100% auto financing.
What about a struggling business?
Now we’ll take a look at the opposite scenario: What does the balance sheet show when a company is losing value instead of gaining?
Let’s say that a year after buying the warehouse and sports car, eReptile falls on hard times.
There have been news reports about teenagers bitten by vipers, and your sales are drying up.
So, you decide to relieve the financial pressure by selling some assets.
First give your Mercedes roadster back to the dealer to pay off the bank.
On the balance sheet this transaction is neutral because 100% financing means the same amount appears in both columns.
There’s no effect on owner’s equity, so you didn’t receive any cash by selling, just relief from monthly payments.
eReptile LLC Balance Sheet
2/28/2020
Assets
Cash $30,000
Accounts receivable
Hawk Haven 38,000
Inventory
Snakes 73,000
Lizards 19,000
Vehicles
Delivery truck 26,000
Warehouse 300,000
Total assets $486,000
Liabilities
Accounts payable
Food for snakes 3,000
Food for lizards 2,000
Loan for warehouse 210,000
Credit card debt 50,000
Total liabilities $265,000
Owner’s equity $221,000
Total liabilities & owner’s equity $486,000
Property damage versus price appreciation
The next step is to sell the eReptile warehouse.
You’ve already remodeled the warehouse to accommodate reptiles instead of humans.
Unfortunately, when you try to sell the property you discover that it’s worth a bit less than when you bought it.
The remodeling changes have caused $30,000 damage to the property. Ouch.
On the balance sheet the property’s market value has been reduced from the original purchase price of $300,000 downward to only $270,000 now.
On the asset side of the equation, we lower the value of the warehouse by $30,000 to reflect the damage from remodeling:
But now the equation doesn’t balance, so we’ll need to change the amount of liabilities or owner’s equity.
You haven’t really paid the warehouse loan down very much in a year’s time.
So, the loan balance is still around $210,000.
The only way to balance the equation is by taking that $30,000 loss out of the owner’s equity.
eReptile LLC Balance Sheet
3/31/2020
Assets
Cash $30,000
Accounts receivable
Hawk Haven 38,000
Inventory
Snakes 73,000
Lizards 19,000
Vehicles
Delivery truck 26,000
Warehouse 270,000
Total assets $456,000
Liabilities
Accounts payable
Food for snakes 3,000
Food for lizards 2,000
Credit card debt 30,000
Loan for warehouse 210,000
Total liabilities $245,000
Owner’s equity $211,000
Total liabilities & owner’s equity $456,000
After selling the warehouse, here’s what the balance sheet looks like:
eReptile LLC Balance Sheet
4/30/2020
Assets
Cash $30,000
Accounts receivable
Hawk Haven 38,000
Inventory
Snakes 73,000
Lizards 19,000
Vehicles
Delivery truck 26,000
Total assets $186,000
Liabilities
Accounts payable
Food for snakes 3,000
Food for lizards 2,000
Total liabilities $5,000
Owner’s equity $181,000
Total liabilities & owner’s equity $186,000
Now let’s consider the opposite scenario: Let’s assume that local real estate values are rising quickly overall.
Even if you’ve damaged the warehouse during remodeling, that equity loss can still be overcome through the magic of price appreciation over time.
In that case, if the market value of eReptile’s real estate rises to at least 0,000 it will override the earlier damage loss of ,000.
The value of your owner’s equity would increase accordingly.
Paying off credit card debt on the balance sheet
Let’s take a look at what happens when you pay down the credit card debt using cash, but don’t sell the warehouse:
eReptile LLC Balance Sheet
4/30/2020
Assets
Cash 0
Accounts receivable
Hawk Haven 38,000
Inventory
Snakes 73,000
Lizards 19,000
Vehicles
Delivery truck 26,000
Warehouse 270,000
Total assets $426,000
Liabilities
Accounts payable
Food for snakes 3,000
Food for lizards 2,000
Loan for warehouse 210,000
Total liabilities $215,000
Owner’s equity $211,000
Tottal liabilities & owner’s equity $426,000
Suppose that you’ve survived the earlier financial crisis by selling your car.
But now you’ve heard some troubling news about anti-reptile legislation pending in Congress.
So, you decide to reduce eReptile’s financial risk even further by paying off its $30,000 credit card debt.
Of course this debt appears on the liabilities side of the sheet.
But in order to balance, something needs to be changed elsewhere.
The change is made to the asset column by reducing the cash account.
That’s because you’re taking the same amount of cash out of assets in order to balance against the liabilities.
Notice that paying the debt has no effect on owner’s equity.
Conclusion
Understanding the difference between assets and liabilities is easier if you keep in mind that assets are things you control (whether owned or not), and liabilities are debts you owe.
When you’re thinking about buying a business, understand the distinction between tangible and intangible assets.
Be very cautious when someone offers to sell you a business at a much higher price than the book value of its liquidated assets.
If you want to know whether a business is being offered for sale at a fair price, it’s easy.
Just consider the amount of goodwill, then calculate the company’s book value and compare that with the amount listed as owner’s equity in its current balance sheet together with earlier versions.
Any thoughts about how to check balance sheets from eCommerce businesses? Please leave a comment below.
References
Links
Forbes article https://www.forbes.com/sites/forbesfinancecouncil/2018/10/12/eight-crucial-questions-to-ask-when-choosing-the-right-cpa/#5a8e10f03e5c
Investopedia article https://www.investopedia.com/terms/t/tangibleasset.asp
Inc. article https://www.inc.com/encyclopedia/goodwill.html
Open-source images
Teeter totter from Wikimedia Commons https://commons.wikimedia.org/wiki/File:Teetertotter.jpg
Green Snake from Wikimedia Commons https://commons.wikimedia.org/wiki/File:_Green_vine_snake_.jpg
https://commons.wikimedia.org/w/index.php?curid=75290151
Snakeskin Boots By I, Gobeirne, CC BY 2.5, https://commons.wikimedia.org/w/index.php?curid=3596348
Balance Sheet Equation Orange Graphic http://www.svtuition.org/2015/06/balance-sheet-basics.html