Balance sheet is basically, Total Asset = Total Liability + Total Equity. If one reads an year’s balance sheet statement of a company it will show how much accumulated wealth the company has amassed till that day. In this article we will try to learn how to read and analyze balance sheets of companies as they happen to be the basis of all wise investments.

Shareholder’s Equity/Net Worth

One of the most important financial indicator detailed in the Balance Sheet is shareholders equity or also better known as Net Worth of a company. Net worth of a company is equal to total capital generated by the company by issuing shares plus the retained earnings/reserves. A continuously improving net worth is what investors likes to see. Compare last five years net worth of a company and check if it has grown and at what rate. If is important to check that if the net worth has grown only because of issuance of more shares to public or the retained earnings/reserves has grown. Improving reserves making net worth grow is ideal.

The Working Capital

A healthy working capital is a sign of a prospective company. A company which has good working capital works very freely in the market. You can find working capital by subtracting current liability from current assets. The high the working capital the better because it shows the company has good liquid cash to work more flexibly. If the company is carrying too much debt then working may also go down to as low as a negative value. In order for a company to grow in long term they must show continuously improving (positive) working capital. This is a very good health indicator about a business.

Balance sheet tells us about the financial leverage of a company

Financial Leverage of a company allows investors to compare two difference companies on basis of their debts. Needless to say that the company that has higher debts will be less favorable. But in order to compare two companies we have to first bring them into same analyzing platform. Financial leverage is a tool that allows us to compare apple with apple. Financial leverage is the ration of companies long term debt and equity/net worth. It must be noted that debts are not always bad. Some profitable companies avail to cheaper debts from banks/institutions and generate profits. But of course too much debt is also not good, because in times of crisis (like bankruptcy/liquidation) it will be hard to pay back those debts and there will no money/profits left for shareholders to share.

The level of debt can also be assessed by using a ratio called as debt/asset ratio. This tool also allows investors to compare apple to apple. But it is important to understand that what debt/asset ratio tells about the company. Most of the companies’ assets (like inventories, account receivables, money market linked investments, cash) are financed by availing debts or equity. If debt/asset ratio is more than one means that they are under excess leverage. Excess leverage is a bad sign indicating abnormal debts levels. But if this ratio is less than one it means most of the companies’ assets are financed by equity which is the ideal way of operating the business.

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