What is a balance sheet?
A balance sheet is one of the most important financial statements that feature in a company's reports and reveals details about assets, liabilities, and shareholder equity. More detailed reports can be extracted from a balance sheet, including the company's capital structure and return for investors.
In other words, the balance sheet gives information in a snapshot of what the company owns and owes alongside the amount invested by shareholders. Financial experts can use this report to perform fundamental analysis and calculate financial ratios.
Remember that a balance simply gives overview information as far as the company's current finances are concerned. It does not reveal details of what is happening in the company in the long run. Therefore, to make the most of a balance sheet, it ought to be compared to what was obtained in the previous years.
Different ratios normally help investors to understand a company's financial well-being. The majority of these ratios can be derived from the balance sheet, including the acid-test ratio and debt-to-equity ratio. Investors can also gain useful information from the statement of cash flows and the income statement.
The balance follows a standard account equation that incorporates assets on one side while liabilities and shareholder equity are on the other hand.
Assets = Liabilities + Shareholder's Equity
The formula reveals that a company can pay for the things under its ownership (assets) using money borrowed (liabilities) or by inviting investors (shareholder equity).
Whatever you do, a balance sheet must 'balance.' That is, total assets should be equal to liabilities plus shareholder equity. Hence the name.
When the balance sheet fails to balance, it points toward potential problems such as exchange rate errors, inventory issues, misplaced data, miscalculations, or incorrect data.
Even when evaluating the balance sheet from a general perspective, each of the components that make it up can have small accounts that further break down the company's finances. Different industries maintain different accounts and terms used. Whereas one term may mean a certain thing in an industry, it can have an entirely different implication in another sector.
However, there are some components that remain standard across the industry. For instance, in the assets category, there is property, cash, and inventory, while the liabilities section contains loans, taxes, utilities, wages, and rent. Similarly, shareholder's equity is characterized by retained earnings.
What makes up a balance sheet?
A balance sheet is made up of three primary components, namely assets, liabilities, and shareholder's equity. Here is a closer look at each of these segments.
An asset is a resource used by an individual, corporation or country to perform an economic activity with the expectation that it will generate a future benefit. Assets are normally reported on the balance sheet and fall under the following classification – current assets, fixed assets, financial assets, and intangible assets. They can be bought or created with the goal of increasing the company's value.
When trying to understand assets, think of them as things that you can use in the future to generate cash flow, improve sales, or reduce expenses, regardless of what they are.
An asset can sometimes mean the access that individuals or companies lack. Additionally, it may be possible to legally enforce rights or other types of access, meaning that the company gets to use economic resources at its discretion. The owner retains the right to limit its use.
Something can only be said to be an asset of the company that has the right to it at the time of issuing financial statements.
Assets fall under broad categories:
- Current asses
- Fixed assets
- Financial investments
- Intangible assets
Accounting considers some assets to be current if they are short-term economic resources that can be converted into cash in less than a year. Examples of current assets include inventory, accounts receivable, cash, cash equivalents, and some prepaid expenses.
Whereas valuing cash is pretty straightforward, accountants normally reassess the recoverability of accounts receivable and inventory. If a receivable proves to be uncollectable, it is dubbed as impaired. Similarly, companies right off inventory that becomes obsolete.
It is important to note that some companies record the balance sheet using historical costs. In this case, historical cost refers to the original cost of the asset when it was bought. It may comprise costs like delivery and setup that the company paid for when deploying the asset into operations.
These are resources that are expected to last in the company for more than one year. Examples include buildings, equipment, and plants. Accountants normally apply depreciation to such assets so that the current value can reflect their age. Depreciation allocates the cost of the asset over time. However, it may or may not accurately reflect the loss of earning power.
The term fixed implies that these assets would not be used up or sold in less than a year (accounting period). One feature of fixed assets is that they have a physical form. Additionally, these assets are reported on the balance sheet as PP&E.
Different reasons contribute to the company's motivation to buy fixed assets, including:
- For use in the organization
- To rent to third parties
- To produce or supply goods or services
The mode of depreciating fixed assets can impact the book value and may even cause it to differ from the market value at which the item can be sold. However, land as a fixed asset cannot be depreciated.
Buying or disposing of a fixed asset is normally recorded on the cash flow statement under cash flow from investing activities. Buying fixed assets represents a cash outflow while selling a fixed asset is a cash inflow. An asset whose value is below the net book value undergoes impairment write-down.
Financial assets are the assets resulting from contractual agreements on future cash flows or those due to ownership of equity instruments on another entity. Financial assets differ from PP&E assets because they have a counterparty. PP&E assets include machinery, buildings, and land. A financial asset can be labeled as current or non-current on the balance sheet.
It is very important that you understand how to report the value of financial assets on the balance sheet. However, no single measurement technique can be said to be suitable for all types of assets. In cases where the investment is relatively small, it becomes simple to measure the current market price. However, when the company has majority shares in another company, it is not relevant to measure market price since there is no intent to sell shares.
Intangible assets are the nonphysical assets that the company intends to use in the long term. These assets are often intellectual assets. Accounting and valuation of intangible assets often prove challenging, mainly due to the way such assets are handled. Since there is no certainty about their future needs, assigning value to such assets becomes difficult. At the same time, useful life varies from being identifiable to non-identifiable. An asset whose useful life is more than one year is mom intangible.
There are various intangible assets that are intellectual property. These include:
- Licensing agreements
Other elements that make up intangible assets include service contracts, internet domain names, manuscripts, blueprints, computer software, joint ventures, permits, and medical records. Intangible assets have the benefit of adding future worth to the company and may sometimes be more valuable than tangible assets.
Acquired intangible assets are normally listed on the balance sheet. Similarly, assets that have identifiable value and useful lifespan also make it to the balance sheet. Intangible assets with identifiable value and lifespan appear on the balance sheet as long-term assets based on their amortization schedules and purchase prices. On the other hand, intangible assets that have infinite life do not appear on the balance sheet since they are not amortized. An example of such an asset is goodwill.
Liabilities refer to the money that the company owes to third parties, which includes utilities, rent, and salaries. Current liabilities are normally in the order of their due date and are typically due within one year. On the other hand, long-term liabilities have a due date of more than one year.
Current liabilities refer to the company's short-term financial obligations, which are supposed to be settled within one year or the cash conversion cycle. The cash conversion cycle is how long it takes the company to buy inventory and convert it to cash through the sales process. The amount that the company owes suppliers through accounts payable is an example of current liabilities.
Current liabilities are typically paid off using current assets, which include accounts receivables or cash. Determining the ratio between current assets and current liabilities reveals the company's ability to settle its debts.
The company's accounts payable makes up one of the biggest parts of current liabilities on the balance sheet. It accounts for unpaid supplier invoices. A good running business sets its accounts receivable due date in such a way that receivables are collected before the supplier due date.
In a situation where the supplier gives 60 days payment terms, the company would set its customer's payment terms to 30 days. It is possible to also settle current liabilities by creating another short-term liability.
Examples of current liabilities that appear on the balance sheet include:
- Dividends payable
- Accounts payable
- Income taxes that the company owes in that year
- Short-term debt like commercial paper or bank loans
- Interest applicable on outstanding debts
- Current maturities of long-term debt
- Notes payable
Some businesses maintain an account called other current liabilities. This is a catch-all line for incorporating other liabilities that are to be settled in the year but not classified elsewhere. Current liabilities are not constant. Instead, they vary widely depending on industry and government regulations.
The current ratio is a measure of a company's ability to pay its short-term financial obligations or debts. The formula for the current ratio is current assets / current liabilities. Investors use this ratio to gauge sufficient current assets on its balance sheet that can offset current debt and other accounts payables.
A related calculation, quick ratio, reveals the liquidity of a company in a more conservative approach. It is the same as the current ratio but subtracts the value of total inventories beforehand.
As the name suggests, these are liabilities that the company has more than one year to settle. They include:
- Interest and principal on bonds issued.
- There is also pension fund liability, which is the money that the organization is supposed to pay into employees' retirement accounts.
- Deferred tax liability is the accrued amount that does not have to be paid within the year.
There are some liabilities that may be classified as off the balance sheet. These do not appear on the balance sheet.
3. Shareholder Equity
Shareholder equity refers to the money that belongs to business owners or shareholders. The other term used is net assets because shareholder equity is calculated as total company assets, fewer liabilities, or the debts that the company owes.
Shareholder equity is an important metric that analysts and investors can count upon to make better investment decisions. It forms the basis for determining the value of company-related financial ratios.
Shareholder equity = total assets – total liabilities
Details about shareholder equity are available on the balance sheet.
Retained earnings are the money that the company keeps to reinvest in the business and settle its debt. The amount that remains thereafter is shared with the shareholders in the form of dividends.
The balance sheet is an important metric for companies of all sizes, large or small. It is a useful tool for determining risk, information that investors can use to make better decisions while business owners get to see the firm's exposure. With a single glance at the balance sheet, you get to see what the company owns against what it owes. You can tell whether the company has sufficient funds at hand to meet its short-term demands.