A balance sheet is one of the significant financial documents which states the financial well-being of a company or business. It is a part of the financial statements that include the balance sheet, income statement, cash flow statement, and statement of retained earnings. The balance sheet consists of the company’s assets, liabilities, and shareholders’ equity considered for a specific period. It depicts the total assets of a company and how these assets are being financed (via debt or equity). The balance sheet is updated timely based on the company’s standards and government policies. The investors rely on the balance sheet to understand what the company owns and owes. Further, the balance sheet serves as the key to financial modeling and accounting.
Geeky Takeaways:
- The balance sheet is a financial statement depicting the worth of a company based on the assets, liabilities, and shareholders’ equity. In other words, a balance sheet is a statement of net worth or a statement of the financial health of a business.
- The basic formula applied to the balance sheet is Assets = Liabilities + Shareholders’ Equity.
- It gives a summary of the financial position of a company and displays the amount the company owns and owes.
- The net worth is the book value of the company and the date or time period on which the assets and liabilities of the company are tallied is known as the reporting date.
- The balance sheet is divided into two categories: Assets (current and non-current assets) and Liabilities (current and non-current liabilities). Here, the non-current assets or liabilities depict the long-term assets or liabilities.
How Balance Sheet Work?
1. Serves as a Financial Document: The balance sheet serves as a significant financial document for investors and stakeholders to understand the performance of a company. It helps as a reference through which the investors can make decision investment decisions.
2. Compares the Assets and Liabilities: With the help of the balance sheet, current assets and liabilities can be compared to measure the liquidity of the business or determine the rate at which returns can be generated.
3. Depicts the Trend of Performance: Balance sheets from different time periods or rather consecutive periods can be compared to understand the operation and running of a business.
4. Measures Different Financial Ratios: Some of the significant financial ratios can be calculated using the balance sheet. Ratios such as current ratios, debt-to-equity ratios, and assets-to-debt ratios can be measured on a timely basis, i.e., either yearly, monthly, or quarterly.
Types of Assets
Assets in a balance sheet are categorized under two domains: Current (or short-term) assets and Non-current (or long-term) assets.
1. Current Assets
Under the category of current assets, we have cash and cash equivalents, prepaid expenses, inventory, marketable securities, and accounts receivable.
- Cash and Cash Equivalents: These are the most liquid assets having maturities within three months and the company is able to liquidate the equivalents into cash. The cash equivalents are disclosed by the companies in their balance sheet’s footnotes.
- Marketable Securities: Short-term financial instruments issued either for equity or debt securities of a publicly listed company.
- Accounts Receivable: This is a special account created for credit sales and the business expects to recover the amount within a short period of time before becoming a bad debt expense. Here, as the amount is recovered by the bank, the accounts receivable decrease, and the cash increases.
- Inventory: Inventory includes the raw materials, work-in-progress goods and finished goods. In the balance sheet, the amount of all these goods is reported and when the cost of goods sold is mentioned in the income statement, this account is taken into consideration.
These types of assets are a form of long-term investments where liquidation cannot take place and the conversion into cash takes a long period of time (more than 2 to 10 years). These assets can be further distinguished into tangible, intangible, fixed, operating, and long-term non-operating assets. Some of these assets are land, plants and machinery, patents or intellectual property, trademarks, brands, and goodwill.
- Property, Plant, and Equipment (PP&E): These non-current assets mostly comprise the tangible fixed assets where the value is accounted for based on the accumulated depreciation. This PP&E is classified into Land, Building, and equipment or machinery as per companies’ policies. Except for the land, other all assets are depreciable.
- Intangible Assets: This other category of non-current assets belong which cannot be seen. Companies build goodwill, brand names, and trademarks which are intangible in nature but they do account for a value in the balance sheet. There are identifiable intangible assets (patents, intellectual property, licenses, trademarks, and company secret formulas) and unidentifiable intangible assets (brand name and goodwill).
Types of Liabilities
Liabilities are listed on the right-hand side of the balance sheet. It is basically what the company owes and they are tallied as negative values in the balance sheet as compared to the assets (positive values). They create an obligation to pay the amount to the debtors. The liabilities are also categorized under two heads in the balance sheet: Current liabilities and Non-current liabilities.
1. Current Liabilities
Any liability which is due to the debtor within one year is the current liability. Some of them include payroll expenses, rent payments, utility expenses, accounts payable, debt financing, and other accrued expenses.
- Accounts Payable: The amount a business owes to suppliers for the purchase of goods and materials on credit. As the company pays off its purchase, the value of this account decreases and the company cash also reduces.
- Rent and Utility Payments: These payments are paid within one year or less and hence are considered under the current liabilities.
- Debt Financing: If a company takes a loan and the repayment starts within one year, then the repayment amounts are included in the debt financing. Short-term loans are considered under this category.
2. Non-Current Liabilities
Long-term debt or obligations which are due for more than one year are categorized under non-current liabilities. Different types of these liabilities include leases, loans, bonds payable, provisions for pensions, notes payable, and deferred tax liabilities.
Shareholders’ Equity
Shareholders’ or owner’s equity actually accounts for the share of the owner of the business after the liabilities are accounted for. In reality, if all the resources of the business (owns or assets) are added and all the obligations of the business (owes or liabilities) are subtracted, the remaining amount accounts for the owner’s or shareholders’ equity.
Basically comprises two components: Money and Earnings. Money (or capital) is typically considered the amount of contribution made by the owner in order to run the business and it contributes to the ownership or shares of the business. On the other hand, the Earnings of a business are the profit generated by the business over time and retained.
How to Read a Balance Sheet?
In a balance sheet, the total assets should equate with the total liabilities and shareholders’ equity.
Total Assets = Total Liabilities + Shareholders’ Equity
This above formula depicts that whatever a business owns has been financed by either borrowing money (liabilities) or by raising funds from investors. Also, the business can finance its operations via paid-in capital or via retained earnings. The analysis of the financial state of a business is based on all the financial statements (balance sheet, income statement, and cash flow statement) rather than analyzing independently the individual statements.
Suppose, a company purchases a truck for their logistics. That truck would be included in the asset section of their balance sheet, whereas the loan taken for this purchase would be included in the liability section. Finally, at the financial year end, their income statement would record a depreciation as an expense. Depreciation is the reduced value of the truck due to wear and tear.
Next in the cash flow statement, the depreciation is added to the net income. This affects the closing cash balance (mentioned in the balance sheet. Finally, the notes mentioned below in the financial statements give the explanation of any assumptions made while preparing the balance sheet. The accountants hired for preparing the company’s financial statements, indicate whether these statements are prepared as per the International Financial Reporting Standards (IFRS).
Analyzing a Balance Sheet with Ratios
A balance sheet helps to interpret the financial health of a business. The financial ratios are used by investors and analysts to understand the efficiency and effectiveness of a business. The below-mentioned ratios are crucial for any business.
1. Liquidity Ratios: This shows the amount of liquidity a business can have during times of emergency. Two forms of liquidity ratios are measured: Current Ratio and Quick Ratio.
- Current Ratio: Measured by dividing current assets by current liabilities. Measures the ability of the company to meet its short-term obligations. A value of 1 indicates that the company is liquid enough to sustain itself during times of turmoil.
- Quick Ratio: Measured by dividing the quick assets by the current liabilities. Emphasizes the most liquid assets (except the inventory). A higher quick ratio interprets a better capability to cover short-term obligations without relying on the slow-moving inventory.
2. Leverage Ratios: This ratio depicts how much the company owes and can be represented in two forms.
- Debt-to-Equity Ratio: Measured by dividing the total debt with shareholders’ equity. A greater ratio indicates higher leverage but also is exposed to financial risk.
- Interest Coverage Ratio: Measured by dividing operating income by the interest expense. A higher ratio indicates that the company is able to meet its debt services without any obstacles.
3. Profitability Ratios: This ratio represents the amount of profit earning capacity of the business.
4. Return Ratios: This group of ratios depicts the returns the business is able to generate from its operations.
- Return on Assets (Net Income/Total Assets): The efficiency of the company in generating profit is considered here. If the value is high, then it means that the company is able to use its assets in a more efficient way.
- Return on Equity (Net Income/Shareholders’ Equity): This measures the profit generated using the investments made by the shareholders. Effective use of equity capital is represented by a higher return of equity percentage.
These are some of the major ratios that investors, shareholders, analysts, and management use to interpret the health and position of the company. There are more ratios that represent the efficiency and effectiveness of running the business.
What to Look for in the Company’s Balance Sheet?
In the company’s balance sheet, there are assets (both current and non-current assets), liabilities (short-term and long-term liabilities), and the shareholder’s equity which represents the overall capital and financial health of the company.
Further, one can look into the various financial ratios which depict the efficiency of the business. From liquidity ratios to profitability ratios, all depict the financial health and position of the business. With the help of all the financial statements, the overall performance of a business can be interpreted.
Frequently Asked Questions (FAQs)
What is the difference between a balance sheet and an income statement?
The balance sheet represents a company’s total assets and liabilities at a particular period of time. While, the income statement describes the company’s revenues, expenses and profitability over a particular period (yearly, monthly or quarterly).
Does the balance sheet mention the net income?
The net income is not shown directly in the balance sheet. Nevertheless, the net income is used to calculate the retained earnings.
What are other names for a balance sheet?
Balance sheet is also known as statement of financial condition or statement of financial position.
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