If you are going to run a company or invest in companies, you need to be able to read a balance sheet. This is different to knowing what profit or loss a company has made (i.e. reading a profit and loss account). Why? Because a profit and loss account only shows you half the picture.
For instance, Company X might have a turnover of 1 million and expenses of 500,000, thus it has made a profit of 500,000 and must be doing really well, n’est-ce pas? No, actually. Because what you can’t see from this simple profit and loss account is that it owes the bank 2 million, the 1 million in turnover is very dodgy and there is a 4 million tax bill hanging over its head from previous years’ accounts, a franchise expiring, tax loop hole about to close and a powerful competitor about to start up. Invest in Company X? I don’t think so. It’s bankrupt and fraudulently trading and not worth a pig’s ear. Stay away. So you need to see a balance sheet. Without fail. And because of what it is not telling you.
A balance sheet has to balance. That’s why it’s called a balance sheet.* The basic formula you need to know is Assets minus Liabilities = Equity or A – B = C. Into even simpler terms: what you own less what you owe equals what you are worth. This applies to yourself, companies you work for/own and companies you intend investing in.
Let’s have a closer look.
So if you just hear about a company that has made a profit of 1 million and are offered the chance to invest, don’t be impressed by that single figure. Ask to see the balance sheet. Read it thoroughly. In fact, don’t just read the balance sheet, important as it is, there are other things you need to know, such as a company’s financial statements in total. The more information you can get (and should get), the more solid your decision will be.
* The actual balance is Equity + Liabilities = Assets, thus balancing. You get assets on one side and liabilities and equity on the other.
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