How do I read a company’s balance sheet and which numbers matter most?

This week we’re talking all about the Balance Sheet.

The balance sheet tells you how much capital you have in your business.

All of the accounts in your chart of accounts fall under one of two families: revenue and expense accounts, or asset and liability accounts.

You know the income statement? We’ve spoken a lot about the income statement in the past. And the income statement, that’s where you’re gonna see your revenue and expense accounts.

And for the balance sheet, you wanna look at the asset and liability accounts, that’s what’s gonna be on the balance sheet. Now, the asset accounts are things that you own: the money in the bank account, equipment, and even money customers owe you for work you’ve already delivered. Liabilities are things that you owe, like unpaid bills, like the loans you took from the bank, like the money you took from investors.

Here’s Google’s balance sheet as of December 31, 2009.

We’ll start at the top and we’re gonna work our way down through the balance sheet, kind of like we did with the income statement.

Current Assets

Here we’ve got the cash. Cash is the first line of the balance sheet and the most important number in your business. Cash is like gasoline for the car, when you’re running around out selling stuff, and when it hits empty, it’s empty, and you gotta go fill it up. Alan Shugart, who started Seagate, used to say, “Cash is more important than your mother.” You never want to run out of cash.

The next line is short-term investments. Short-term investments are basically cash. Most startups won’t have one. Here Google’s got $24bn in cash and short-term investments. That’s the smart thing to do, is to have some short-term investments where you can park the cash. Hopefully they’re safe and liquid enough that if you need the cash, you can pull it back out.

And then there’s accounts receivable. That’s what customers owe you for products and services you’ve delivered to them but not yet been paid for. If you’ve done work for someone but haven’t received the check, you can consider that an asset. Here Google calls it net receivables, I guess they netted some money that somebody owes them out of it, I’m not sure why. Typically you don’t want accounts receivable to be a large number. If it’s over three months of your revenue or something like that, something’s wrong. And we’ll talk more about analysis later.

We’re going to skip over these minor lines and just look at the major lines. The total current assets line adds all the little lines together that you can turn into cash quickly. Sometimes current assets are used to measure liquidity.

And then long-term assets. Anything that isn’t quick to turn into cash is a Long-Term Asset. I’m going to take a guess, long-term investments for Google are probably like a bunch of minority investments that they’ve made in other companies, and it would take them a long time to turn those investments into cash. Then there’s property and equipment. The cost of capital equipment. Every year this gets reduced for depreciation. And depreciation happens on the P&L. And then goodwill. Goodwill is really hard to explain. When you buy a company for more than they have on the books, the difference in cost is booked as goodwill. So here’s $4.9bn of goodwill for Google, from deals like YouTube and Doubleclick. If that acquired company ends up losing value over time, the goodwill can be written off and there’s a huge one-time expense on the P&L.

What You Owe Other People

The next one’s the liabilities, what you owe other people. The most important thing after cash is liabilities. If you can’t pay your debts, your business is called bankrupt. You’ll see running out of cash is one way that you can go bankrupt. But plenty of companies can go bankrupt with tons of cash.

So there are two big current liabilities: accounts payable and accrued expenses. These are both money you owe for your business, and you have yet to pay. Accounts payable is for a bill you got in the mail, like an unpaid legal bill. Accrued expenses are where you’ve booked it ahead of the bill, like employee benefits that are accrued every month. Google doesn’t show an accrued expenses line here, it looks like they’re lumping them together.

Current liabilities are also used in some analyses, and current assets can be compared to current liabilities to measure how tight or loose things are. You can see here that Google has $29bn of current assets, and only $2.7bn in current liabilities. No pressure.

Most of the noncurrent liabilities are long term debt. Lots of debt compared to total assets is a worry. When it’s due and the other terms can be found in the footnotes. They’re not in the balance sheet. The size of the amount matters, but the terms matter more.

Stockholders’ Equity

The final section is stockholders’ equity. That’s the money invested by equity investors like VCs and shareholders and the money the company has retained. I’m not sure how they’re breaking it up, so we’ll just use the total amount, which is $36bn. The total equity amount is also called the book value.

Now, for the fun part! Total assets should always equal total liabilities plus stockholders’ equity. Let’s look here at Google: $40.5bn in assets minus $4.5bn in liabilities equals $36bn in equity.

The fact that the balance sheet has to balance is a big help when you analyze and project cash flow.

Of all these lines, cash and liabilities are the most important numbers on the balance sheet. Cash is king. You need it to keep the doors open, pay the employees and operate. If you don’t have cash, you don’t have a business. Liabilities can shut you down. You should always look at cash. You should also always look at liabilities. Watch cash and liabilities to figure out how tight things are.