How To Understand A Balance Sheet: Part 1

90% of investors lose money in the stock market despite their sincere intentions of making money. Isn’t it frightening?

If you ask the 90% if they know what the business owns or owes, it is most likely that they will give you a blank stare.

The 10% who profit consistently are different as they are interested to find out what their businesses own or owe before investing.

So, how do we get such information? The answer lies in a company’s balance sheet. If you are new to it, do not fret. I will share a few things you need to know about balance sheets so that you can interpret it easily.

Here’s part one, understanding a balance sheet.

It is also known as the Statement of Financial Position

This is because a balance sheet tells you what the stock owns or owes in a single point in time. The term ‘balance sheet’ is used interchangeably with ‘Statement of Financial Position’.

Balance Sheets must be Balanced

A balance sheet is formulated with the equation below:

Assets = Equity + Liability

It is similar to purchasing a property with a mortgage. For instance, you buy a property worth $1 million. It is financed by putting down a down payment of $200,000 and obtaining a mortgage of $800,000. Thus, the balance sheet must be balanced and it looks like the diagram below:

Current & Non-Current

Assets and liabilities can be classified under ‘Current’ or ‘Non-Current’.

Let me start with Assets.

Current Assets are assets that can be converted into cash over the next 12 months. This includes cash, short-term deposits, inventories, trade receivables (bills to be collected by your customers), and any short-term investments which can be conveniently converted into cash.

Meanwhile, Non-Current Assets are assets that are not likely to be converted into cash over the next 12 months. Usually, this includes properties (land and buildings), plants and equipment.

Similarly, current liabilities are bills or debts that are to be paid over the next 12 months. Non-current liabilities are bills or debts that are to be settled after 12 months.

Let me illustrate.

Is your mortgage a Current or Non-current liability? The answer is both. Let’s say you have a mortgage of $800,000 where you are required to pay off $20,000 in principal sum over the next 12 months. Therefore, you would have $20,000 in current liability while the remaining $780,000 will be your non-current liability, as you are not required to settle this amount in the next 12 months.

Foolish Summary

You might feel that the financial statement is just a bunch of numbers. However, these numbers are there to tell us a story.

As an investor, it is our job to translate the numbers into a story that we can understand. Understanding the relationship between assets, liabilities and equities is the first step in that story.

If you want to learn more about investing and to keep up to date on the latest financial and stock market news, you can sign up for a FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore

Also, like us on Facebook to follow our latest hot articles. The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.