What is a balance sheet and how to read financial statements

The balance sheet is one of the key tools used to analyse the financial situation of the company. In the financial statements, the balance sheet reflects the state of assets, liabilities and equity at a given point in time. But how do we read a balance sheet to understand the key indicators? This is a step-by-step guide which explains what a balance sheet is and how to analyse its elements effectively.

What is a balance sheet? – basic information

The balance sheet is a part of the financial statements which shows assets (i.e. assets of the company) and liabilities (how it is financed). It is a snapshot of the financial situation of the organisation at the end of the current year.

The structure of the balance sheet includes:

Assets (what the company owns and controls): fixed and current,
Liabilities (sources of funds for assets): equity and liabilities (long-term and short-term).

The balance sheet rule states that:

Assets = liabilities

Any balance sheet must maintaining this balance. Now let us look at the individual parts in more detail.

Assets in the balance sheet – what are they?

Assets are resources controlled by the company, which can provide future benefits. In the balance sheet we distinguish the following items:

1. Fixed assets

Fixed assets are used by the company for an extended period of time (longer than one year). They include:

Fixed assets (e.g. properties, machinery),
Intangible fixed assets (e.g. patents, licences),
Long-term investments (e.g. long-term deposits).

2. Current assets

These are resources which the company intends to use in the short term (up to 12 months). They include:

Stocks (goods, raw materials),
Short-term receivables (e.g. from customers),
Cash and cash equivalents (e.g. cash in accounts).

Liabilities – how to understand the financing side?

Liabilities show where the company acquired the funds for the assets. They are divided into:

1. Equity

This includes the assets of the company’s owners, e.g. shareholder contributions and profits achieved in previous years.

2. Liabilities

These are funds from other parties, which the company must pay back. We distinguish the following items here:

Long-term liabilities (e.g. bank loans),
Current liabilities (e.g. invoices to be paid).

Key balance sheet indicators – how to analyse them?

We should note the following indicators when analysing the balance sheet:

1. Liquidity

Refers to the ability of the company to meet its short-term obligations.

Current liquidity ratio = current assets / short-term liabilities

2. Debt ratio

It indicates the extent to which the company finances its operations using debt.

Overall debt ratio = (liabilities / total assets) * 100%.

3. Return on equity

It indicates how much profit is generated by each zloty of invested equity.

ROE = (net financial income / equity) * 100%.

How to read the account of profits and losses alongside the balance sheet?

The balance sheet is not everything. To carry out a full analysis of the finances, it is worth including an account of profits and losses which shows the following:

Revenue (how much the company has earned),
Costs (how much it has spent),
Profit or loss (the financial result).

Combination of the balance sheet with the account of profits and losses provides a better understanding of the company’s financial position.

The balance sheet and the Accounting Act

The preparation of the balance sheet is governed by the Accounting Act. According to the regulations, the balance sheet must be fair and transparent, and include:

Fixed and current assets,
Liabilities (equity and liabilities),

Why is the ability to read a balance sheet important?

A skilful reading of the balance sheet allows us to:

Assess the financial situation of the company,
Understand where the funds for the business activity come from,
Check what assets and liabilities are present,
Make better business and investment decisions.

How to read a balance sheet – frequently asked questions

How to check if the balance sheet is good?

Check if total assets equal total liabilities. Then analyse the liquidity, debt and profitability ratios.

What should we pay attention to in a balance sheet?

The most important items are current assets, short-term liabilities, equity and financial ratios, which show the liquidity and stability of the company.

What does the balance sheet show?

The balance sheet shows the company’s assets and the sources of its financing (liabilities) at a specific point in time.

How to read the financial result?

The net financial result is the difference between revenue and expenses. It can be found in the account of profits and losses.

What is total assets and total liabilities?

Total assets equals total liabilities and represents the total assets of the company and the sources of its financing.

How to read the financial statements?

The financial statements include the balance sheet, account of profits and losses and notes. Each element provides important data about the company.

Are liabilities debts?

Not just that. Liabilities include both actual liabilities (debts) and equity.

How to find an error in the balance sheet?

Check if total assets equal total liabilities. If not, analyse each item and correct any accounting errors.

Summary

The balance sheet is not just a statement of numbers, but a comprehensive tool enabling assessment of the company’s financial situation. Understanding concepts such as fixed assets, long-term liabilities and equity allows better business decisions to be made. Remember that the balance sheet is a fundamental part of the financial statements and it is a good idea to analyse it together with the account of profits and losses.

If you need help interpreting your balance sheet or bookkeeping, contact our Efekta accountancy firm. With us, accounting will become simple and transparent!