How to Reading the Statement of Financial Position and Understand It for Any Company

The statement of financial position, also known as the balance sheet, is a snapshot of a company’s financial position at a specific point in time. This statement is one of the most important financial statements, providing essential information about a company’s assets (what it owns), liabilities (what it owes), and equity (the value of owners’ investments and retained earnings). Reading the Statement of Financial Position is crucial for understanding these financial elements and assessing a company’s overall financial health.

The role of the statement of financial position isn’t just to present numbers; it goes beyond that to in-depth analysis that allows investors, creditors, and other stakeholders to evaluate the company’s performance and financial position. Reading the Statement of Financial Position helps stakeholders interpret key figures and trends, making it easier to gauge financial stability and operational efficiency.

In this article, we will thoroughly analyze the statement of financial position, discussing the most important financial ratios and indicators derived from it. By Reading the Statement of Financial Position carefully, investors can make informed decisions regarding investments and financing strategies, ensuring they understand the company’s strengths and weaknesses..  

What is the Statement of Financial Position?

The statement of financial position is a financial report that summarizes an entity’s assets, liabilities, and equity at a specific date, usually the end of the financial period. The statement of financial position provides a comprehensive view of the entity’s financial position at that moment and helps assess its liquidity, solvency, and financial structure.

Components of the Statement of Financial Position:

The statement of financial position consists of three main elements:

1. Assets:
   • Definition: Economic resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.  
   • Classification of Assets:
     • Current Assets: Assets that are expected to be converted into cash or used within one year or one operating cycle, whichever is longer. They include:
       • Cash and Cash Equivalents: Includes cash on hand, cash in banks, and highly liquid short-term investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of changes in value.  
       • Accounts Receivable: Amounts owed to the entity by customers for the sale of goods or services.
       • Inventory: Goods held for sale or raw materials used in production.
       • Prepaid Expenses: Expenses that have been paid in advance but the service has not yet been used, such as prepaid rent or prepaid insurance premiums.
       • Short-term Financial Investments: Investments in financial instruments that are expected to be converted into cash within a short period, such as short-term stocks and bonds.
       • Non-current Assets: Assets that are expected to be used for more than one year. They include:
         • Property, Plant and Equipment (PP&E): Tangible assets used in the entity’s operations, such as land, buildings, machinery, equipment, and vehicles. They are presented on the statement of financial position at their net book value (cost less accumulated depreciation).
         • Investment Property: Real estate (land or buildings) held to earn rental income or for capital appreciation, or both.
         • Intangible Assets: Non-physical assets that have economic value, such as patents, trademarks, goodwill, and copyrights.
         • Long-term Investments: Investments in financial instruments that are expected to be held for more than one year, such as long-term stocks and bonds.
         • Deferred Tax Assets: Arising from temporary differences between accounting profit and taxable profit.
2. Liabilities:
   • Definition: Present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow of resources from the entity.  
   • Classification of Liabilities:
     • Current Liabilities: Obligations that are expected to be settled within one year or one operating cycle, whichever is longer. They include:
       • Accounts Payable: Amounts owed to suppliers for the purchase of goods or services.
       • Short-term Loans: Loans that are due within one year.
       • Accrued Expenses: Expenses that have been incurred but not yet paid, such as accrued salaries and accrued interest.
       • Unearned Revenue: Amounts collected in advance from customers for goods or services that have not yet been provided.
     • Non-current Liabilities: Obligations that are expected to be settled after more than one year. They include:
       • Long-term Loans: Loans that are due over more than one year.
       • Bonds: Long-term debt instruments issued by the entity to finance its operations.
       • Deferred Tax Liabilities: Arising from temporary differences between accounting profit and taxable profit.
       • Long-term employee benefits obligations, such as pension plan obligations.
3. Equity:
   • Definition: The residual interest in the assets of the entity after deducting its liabilities. Equity represents the owners’ investments in the entity plus retained earnings.
   • Components of Equity:
     • Capital: Amounts invested by the owners in the entity.
     • Retained Earnings: Accumulated profits that have not been distributed to shareholders.
     • Reserves: Amounts set aside from profits for specific purposes, such as a legal reserve or expansion reserve.
     • Additional Paid-In Capital: The difference between the par value of a share and its selling price when issued.

The Accounting Equation:

The accounting equation is the foundation of the statement of financial position, and it states that:

Assets = Liabilities + Equity

This equation reflects the fact that an entity’s assets are financed either through liabilities (debt) or through equity (owners’ investments and retained earnings).

How to Read the Statement of Financial Position:

• Start by Looking at the Date of the Statement: Remember that the statement of financial position represents a snapshot of the company’s financial position at a specific date.
• Read the Title of the Statement: The title should clearly state the name of the company, the name of the statement (“Statement of Financial Position” or “Balance Sheet”), and the date it covers.
• Examine the Assets:
  • Start with Current Assets: Look for cash, short-term investments, receivables, and inventory. These items indicate the company’s liquidity and its ability to meet its short-term obligations.
  • Then move to Non-current Assets: Look for property, plant, and equipment, long-term investments, and intangible assets. These items indicate the company’s long-term investments.
  • Note any significant changes in asset balances compared to previous periods.
• Examine the Liabilities:
  • Start with Current Liabilities: Look for accounts payable, short-term loans, and accrued expenses. These items indicate the short-term obligations that the company must pay.
  • Then move to Non-current Liabilities: Look for long-term loans and bonds. These items indicate the company’s long-term obligations.
  • Note any significant changes in liability balances compared to previous periods.
• Examine Equity:
  • Look for issued capital, retained earnings, and reserves. These items indicate the amount of the owners’ investments in the company and its accumulated profits.
  • Note any significant changes in equity balances compared to previous periods.
• Verify the Accounting Equation: The total assets must equal the total liabilities and equity.
• Read the Notes to the Financial Statements: The notes contain important additional information about the items in the statement of financial position, such as the accounting policies used and details of assets and liabilities.

Understanding Financial Ratios Derived from the Statement of Financial Position:

Several financial ratios can be derived from the statement of financial position to assess the company’s financial position. Here are some important ratios:

• Liquidity Ratios:
  • Current Ratio:
    • Formula: Current Assets / Current Liabilities
    • Interpretation: Indicates the number of times current assets cover current liabilities. A higher ratio generally indicates better liquidity.
  • Quick Ratio (Acid-Test Ratio):
    • Formula: (Current Assets – Inventory) / Current Liabilities
    • Interpretation: A more conservative measure of liquidity than the current ratio, as it excludes inventory from current assets. It indicates the entity’s ability to meet its short-term obligations without relying on the sale of inventory.
• Solvency Ratios:
  • Debt-to-Equity Ratio:
    • Formula: Total Liabilities / Total Equity
    • Interpretation: Indicates the extent to which the entity relies on debt to finance its assets. A higher ratio generally indicates higher financial risk.
  • Debt Ratio:
    • Formula: Total Liabilities / Total Assets
    • Interpretation: Indicates the proportion of assets financed by debt.
  • Fixed Asset Coverage Ratio:
    • Formula: Net Fixed Assets / Long-term Liabilities
    • Interpretation: Indicates the adequacy of fixed assets to cover long-term liabilities.
• Capital Structure Ratios
  • Leverage Ratio:
    • Formula: Total Assets / Total Equity
    • Interpretation: Indicates the ammount of assets financed by equity. Importance of Reading and Understanding the Statement of Financial Position:

Reading the Statement of Financial Position and understanding the statement of financial position is an essential skill for any investor, creditor, or stakeholder seeking to assess a company’s financial position. The statement of financial position provides valuable information about:

• Company Size and Asset Structure: The statement of financial position shows the size of the company through its total assets, and it also shows how these assets are distributed between current and non-current assets.
• Company Financing Sources: The statement of financial position shows how the company’s assets are financed, whether through debt (liabilities) or through equity.
• Company’s Ability to Meet its Obligations: Reading the Statement of Financial Position helps assess the company’s ability to meet its short-term and long-term obligations.
• Risks of Investing in the Company: The statement of financial position helps assess the company’s financial risks, such as the risk of bankruptcy or inability to repay debts.
• Company Management Efficiency: Information from the statement of financial position can be used to assess the efficiency of company management in using its assets and generating a return on investment.

Points to Pay Attention to When Reading the Statement of Financial Position:

• Reading the Statement of Financial Position is essential for a comprehensive financial analysis. When analyzing a company’s financial position, it is crucial to compare figures with previous periods to track changes in assets, liabilities, and equity. By reading the statement of financial position, investors and analysts can identify trends that may impact future performance. Additionally, comparing figures with competitors within the same industry provides insights into the company’s relative standing.
• A key aspect of reading the statement of financial position is focusing on material items such as cash, receivables, inventory, and long-term debt, as these elements directly influence financial stability. Furthermore, it is essential to read the notes to the financial statements, as they provide critical details regarding accounting policies, asset valuation, and liability disclosures.
• Finally, reading the statement of financial position helps in detecting warning signs, such as a sharp decline in cash reserves or a sudden increase in debt, which could indicate potential financial distress. By carefully reading the statement of financial position, stakeholders can make informed decisions based on a thorough understanding of the company’s financial health.

Role of Technology in Reading the Statement of Financial Position and Analyzing the Statement of Financial Position:

Accounting software and Enterprise Resource Planning (ERP) systems provide advanced analytical tools that help in reading and understanding the statement of financial position more efficiently and effectively, by:

• Automatically calculating financial ratios.
• Creating graphs and charts that show trends in financial ratios over time.
• Performing comparative analyses with other companies in the same industry.
• Identifying strengths and weaknesses in the entity’s financial position.
• Forecasting future financial performance based on historical data.

Practical Example of Analyzing the Statement of Financial Position:

Company “Al-Amal”:

Analysis:

• Current Ratio: The current ratio improved from 1.5 in 2022 to 1.8 in 2023, indicating an improvement in the company’s liquidity.
• Quick Ratio: The quick ratio improved from 0.8 in 2022 to 1.0 in 2023, indicating an improvement in the company’s ability to meet its short-term obligations without relying on the sale of inventory.
• Debt-to-Equity Ratio: The debt-to-equity ratio decreased from 1.2 in 2022 to 1.0 in 2023, indicating an improvement in the capital structure and a decrease in financial risk.

Conclusion:

Reading the Statement of Financial Position and understanding the Statement of financial position is an essential skill to evaluate any company’s financial standing. By understanding the components of the statement of financial position, and by using ratio analysis and horizontal and vertical analysis techniques, investors, creditors, and other stakeholders can make more informed decisions. Remember that the statement of financial position is part of the complete set of the financial statements, and should be read alongside

the income statement, the statement of cash flows, statement of changes in equity and the accompanying notes in order to get a complete view of the company’s performance and financial standing. Mastering the skill of Reading the Statement of Financial Position boosts your financial literacy, and helps you succeed in the business and investment world. Finally, technology developments facilitate the statement of financial position reading, and improve the quality and accuracy of the given financial information