Balance Sheet

Table of Contents

What is a Balance Sheet?
Example of a Balance Sheet
How is a Balance Sheet Structured?
What can a Balance Sheet Tell You About a Company?
Importance of Balance Sheets
Frequently Asked Questions

What is a Balance Sheet?

Balance Sheet

A balance sheet is a financial document that outlines a company’s assets, liabilities, and shareholders’ equity at a specific moment. It provides a snapshot of what the business owns (assets) and what it owes (liabilities).

The formula for a balance sheet is:

Assets = Liabilities + Shareholders’ Equity

This equation is based on the double-entry accounting principle, where every transaction impacts at least two accounts. For the balance sheet to balance, the total of both sides must be equal: a debit in one account must be offset by a credit in another.

Example of a Balance Sheet

Suppose Company XYZ takes a 5-year loan of US$4,000 from a bank. Its assets column, which includes its cash account, will now have US$4,000 more. Similarly, its liabilities column will increase by US$4,000.

If XYZ takes US$8,000 from investors, its assets column will increase by US$8,000. So will its shareholders’ equity entry.

How is a Balance Sheet Structured?

A balance sheet typically has five sections:

Current Assets: These are assets that can be liquidated in a short period of time.
- Cash and Equivalents: Funds in current and savings accounts and money market instruments.
- Accounts Receivable: Payments pending from customers.
- Inventory: Raw materials or finished goods held by the company.
Non-Current Assets: These refer to assets that a firm owns for the long term.
- Plant, Property and Equipment: Physical or tangible long-term assets that have a lifespan of more than one year. Examples are buildings, machinery, land, office equipment, furniture and vehicles.
- Intangible Assets: Non-physical assets like copyrights, patents, brands, trademarks that the company owns.
Current Liabilities: These are obligations that are due in a short period, generally under a year.
- Accounts Payable: Money owed by the business for items that are bought on credit.
- Current Debt/Notes Payable: Debt that needs to be cleared within a year.
- Current Portion of Long-Term Debt: The portion of long-term debtthat must be paid within the current year.
Non-Current Liabilities: Obligations or debts that need to be paid beyond the current financial year.
- Bonds Payable: Amount owed to bond holders by the company.
- Long-Term Debt: Debt thatmatures in more than one year.
Shareholders’ Equity: Funds invested in the company by its stakeholders.
- Share Capital: Themoney a company raises by issuing common or preferred stock.
- Retained Earnings: The portion of net income after the company pays out dividends that is reinvested in the business for future growth purposes.

What can a Balance Sheet Tell You About a Company?

The balance sheet is typically read in conjunction with a company’s income statement and cash flow statement to provide a holistic picture of its financial position. The financial metrics that one can derive from these financial statements are:

Liquidity: One can assess the liquidity of a firm by comparing its current assets to its current liabilities.
Efficiency: Efficiency ratios show how well a company is using its assets and liabilities. Efficiency ratios are calculated from numbers in the income statement and balance sheet.
Rates of Returns: Investors also use the balance sheet to estimate potential rates of returns on their investments. Common measurements of returns are Returns on Equity (ROE), Returns on Assets (ROA) and Returns on Invested Capital (ROIC)

Importance of Balance Sheets

The balance sheet provides a snapshot of a company’s financial position, showing its assets, liabilities, and equity at a specific moment in time. It helps investors understand what a company owns and owes and the amount invested by shareholders. The balance sheet offers valuable insights by illustrating how much money would remain if all assets were sold and debts paid. Lenders and investors use this information to determine whether to extend credit or invest in the company and to assess the appropriate amounts.

Frequently Asked Questions

What is the most important item on the balance sheet?

One key component of a balance sheet is typically shareholders’ equity, which shows the remaining interest in the business after settling all liabilities. This offers a view of the company’s net worth and gives insight into its financial strength and future value.

Investors also pay attention to:

Assets, particularly current assets like cash and receivables, which demonstrate liquidity and the company’s ability to meet short-term obligations.

Liabilities, especially long-term debt, to understand the company’s leverage and risk exposure.

These factors help investors gauge a company’s overall financial health, profitability prospects, and risk level.

Which parts of the balance sheet should investors analyse when picking stocks?

Investors generally look at:

Liquidity

Inventory levels

Accounts receivable

Cash holdings

Debt-to-equity ratio

Return on assets

What is considered a healthy balance sheet?

A strong balance sheet requires more assets than liabilities. Financially strong companies typically have healthy cash balances and low debt levels.

How do I compare the balance sheets of two companies in the same sector?

One of the most effective ways to compare two businesses is to perform a ratio analysis of the two companies using their balance sheets. The ratios include liquidity ratios, solvency ratios, and profitability ratios.

What Are the Uses of a Balance Sheet?

A balance sheet plays a crucial role for various stakeholders by serving multiple purposes:

Evaluating Financial Health: It offers a clear snapshot of a company’s financial status, detailing its assets (what it owns) and liabilities (what it owes) at a specific moment.

Assessing Liquidity: By examining current assets and liabilities, investors and creditors can gauge the company’s ability to meet its short-term obligations.

Analyzing Leverage: The balance sheet shows the level of debt a company carries, aiding in the assessment of financial risk and long-term stability.

Tracking Growth: Comparing balance sheets over time helps stakeholders monitor a company’s financial progress or uncover issues.

Guiding Investment Decisions: Investors rely on balance sheets to evaluate a company’s net worth, profitability, and potential risks before committing capital.