Table of Contents
What is a Balance Sheet?
A balance sheet is a financial statement that records a company’s assets, liabilities and shareholders’ equity at any point in time. It summarises what the company owns (assets) and owes (liabilities).
In a balance sheet:
Assets = Liabilities + Shareholders’ Equity
This equation arises from the way accounts are kept using the double-entry accounting principle. Each side of the equation must match the other: when one account is debited, another must be credited.
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 is a snapshot of the financial status of a company. It tells investors what a business owns (assets), what it owes (liabilities) and how much investors have invested (equity) in the company at a particular point in time. It gives one an indication of how much money the company would have left after selling all its assets and paying off all its debts.
Lenders and investors often look at balance sheets to help them decide whether to lend to or invest in a company and by how much.
Frequently Asked Questions
Cash and debt are among the most important items on a balance sheet for investors.
Investors generally look at:
- Inventory levels
- Accounts receivable
- Cash holdings
- Debt-to-equity ratio
- Return on assets
A strong balance sheet needs to have more assets than liabilities. The balance sheets of financially strong companies typically have healthy cash balances and low debt levels.
One of the most effective ways to compare two businesses is to perform ratio analysis of the two companies using their balance sheets. The ratios include liquidity ratios, solvency ratios and profitability ratios.
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