What is a Balance Sheet?
A balance sheet is one of four basic accounting financial statements. The other three being the income statement, state of owner’s equity, and statement of cash flows. The balance sheet uses the accounting equation (Assets = Liabilities + Owner’s equity) to show a financial picture of the business on a specific day. In other words, a balance sheet lists all of the assets that a company owns as well as the debts owed by the company and the owner’s interest or ownership share in the company.
Balance sheet is the financial statement of a company which includes assets, liabilities, equity capital, total debt, etc. at a point in time.
In financial accounting, a balance sheet or statement of financial position or statement of financial condition is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business partnership, a corporation, private limited company or other organization such as government or not-for-profit entity. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a “snapshot of a company’s financial condition”. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business’ calendar year.
Assets are listed separately first and liabilities and owner’s equity are listed together second. Think about the accounting equation:
Assets = Liabilities + Owner’s equity
Assets have to total the sum or liabilities and owner’s equity. This is where the “balance” in balance sheet comes from. Assets have to balance with liabilities and owner’s equity.
What Does Balance Sheet Mean?
A standard company balance sheet has two sides: assets on the left, and financing on the right–which itself has two parts; liabilities and ownership equity. The main categories of assets are usually listed first, and typically in order of liquidity. Assets are followed by the liabilities. The difference between the assets and the liabilities is known as equity or the net assets or the net worth or capital of the company and according to the accounting equation, net worth must equal assets minus liabilities.
Another way to look at the balance sheet equation is that total assets equals liabilities plus owner’s equity. Looking at the equation in this way shows how assets were financed: either by borrowing money (liability) or by using the owner’s money (owner’s or shareholders’ equity). Balance sheets are usually presented with assets in one section and liabilities and net worth in the other section with the two sections “balancing”.
A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words: businesses have assets and so they cannot, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words, businesses also have liabilities.
The balance sheet has some limitations. For example, the property, plant and equipment are reported at cost minus the accumulated depreciation (except land). If these assets have increased in value, the fair value is not reported because of the cost principle. Also, brand names and trademarks may have significant value, but cannot be reported on the balance sheet unless they were acquired in a business transaction.
The Purpose of a Balance Sheet
Because the balance sheet reflects every transaction since your company started, it reveals your business’s overall financial health. At a glance, you’ll know exactly how much money you’ve put in, or how much debt you’ve accumulated. Or you might compare current assets to current liabilities to make sure you’re able to meet upcoming payments.
The information in your company’s balance sheet can help you calculate key financial ratios, such as the “debt to equity” ratio, which shows the ability of a business to pay for its debts with equity. Even more immediately applicable is the current ratio: current assets / current liabilities. This will tell you whether you have the ability to pay all your debts in the next 12 months.
You can also compare your latest balance sheet to previous ones to examine how your finances have changed over time. You’ll be able to see just how far you’ve come since day one.
The balance sheet should be read with the other financial statements (income statement, statement of comprehensive income, statement of cash flows, and the statement of changes in stockholders’ equity) including the notes to the financial statements.
What Items are on a Balance Sheet?
A balance sheet reports the assets, liabilities and shareholders equity of your business at a given point in time. The items reported on the balance sheet correspond to the accounts outlined on your chart of accounts. A balance sheet is made up of the following elements:
Within the assets segment, accounts are listed from top to bottom in order of their liquidity – that is, the ease with which they can be converted into cash. They are divided into current assets, which can be converted to cash in one year or less; and non-current or long-term assets, which cannot.
Here is the general order of accounts within current assets:
- Cash and cash equivalents are the most liquid assets and can include Treasury bills and short-term certificates of deposit, as well as hard currency.
- Marketable securities are equity and debt securities for which there is a liquid market.
- Accounts receivable refers to money that customers owe the company, perhaps including an allowance for doubtful accounts since a certain proportion of customers can be expected not to pay.
- Inventory is goods available for sale, valued at the lower of the cost or market price.
- Prepaid expenses represent the value that has already been paid for, such as insurance, advertising contracts or rent.
Long-term assets include the following:
- Long-term investments are securities that will not or cannot be liquidated in the next year.
- Fixed assets include land, machinery, equipment, buildings and other durable, generally capital-intensive assets.
- Intangible assets include non-physical (but still valuable) assets such as intellectual property and goodwill. In general, intangible assets are only listed on the balance sheet if they are acquired, rather than developed in-house. Their value may thus be wildly understated – by not including a globally recognized logo, for example – or just as wildly overstated.
Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within one year and are listed in order of their due date. Long-term liabilities are due at any point after one year.
Current liabilities accounts might include:
- current portion of long-term debt
- bank indebtedness
- interest payable
- wages payable
- customer prepayments
- dividends payable and others
- earned and unearned premiums
- accounts payable
Long-term liabilities can include:
- Long-term debt: interest and principal on bonds issued
- Pension fund liability: the money a company is required to pay into its employees’ retirement accounts
- Deferred tax liability: taxes that have been accrued but will not be paid for another year (Besides timing, this figure reconciles differences between requirements for financial reporting and the way tax is assessed, such as depreciation calculations.)
Some liabilities are considered off the balance sheet, meaning that they will not appear on the balance sheet.
Shareholders’ equity is the money attributable to a business’ owners, meaning its shareholders. It is also known as “net assets,” since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to non-shareholders.
Retained earnings are the net earnings a company either reinvests in the business or use to pay off debt; the rest is distributed to shareholders in the form of dividends.
Treasury stock is the stock a company has repurchased. It can be sold at a later date to raise cash or reserved to repel a hostile takeover.
Some companies issue preferred stock, which will be listed separately from common stock under shareholders’ equity. Preferred stock is assigned an arbitrary par value – as is common stock, in some cases – that has no bearing on the market value of the shares (often, par value is just $0.01). The “common stock” and “preferred stock” accounts are calculated by multiplying the par value by the number of shares issued.
Additional paid-in capital or capital surplus represents the amount shareholders have invested in excess of the “common stock” or “preferred stock” accounts, which are based on par value rather than market price. Shareholders’ equity is not directly related to a company’s market capitalization: the latter is based on the current price of a stock, while paid-in capital is the sum of the equity that has been purchased at any price.
Example of a Balance Sheet
BALANCE SHEET as at __________ (Date)
|Current Assets:||Current Liabilities:|
|Cash in Bank||$18,500.00||Accounts Payable||$4,800.00|
|Petty Cash||$500.00||Wages Payable||$14,300.00|
|Net Cash||$19,000.00||Office Rent||—|
|Accounts Receivable||$5,300.00||Federal Income Tax Payable||$2,600.00|
|Total Current Assets||$55,200.00||Customer Deposits||$900.00|
|Fixed Assets:||Union Dues Payable||—|
|Buildings||$330,000.00||Sales Tax Payable|
|Less Depreciation||$50,000.00||Total Current Liabilities||$24,950.00|
|Net Land & Buildings||$430,000.00|
|Net Equipment||$33,000.00||Total Long-Term Liabilities||$195,000.00|
|Owner – Draws||$50,000.00|
|Total Owners’ Equity:||$298,250.00|
|TOTAL ASSETS||$518,200.00||LIABILITIES AND EQUITY||$518,200.00|
Importance of Balance Sheet:
Balance sheet analysis can say many things about a company’s achievement. Few essential factors of the balance sheet are listed below:
- Creditors, investors, and other stakeholders use this financial tool to know the financial status of a business.
- It is used to analyze a company’s growth by comparing different years.
- While applying for a business loan, a company has to submit a balance sheet to the bank.
- Stakeholders can find out the business accomplishment and liquidity position of a company.
- Company’s balance sheet analysis can detect business expansion and future expenses.
The balance sheet is a very important financial statement for many reasons. It can be looked at on its own, and in conjunction with other statements like the income statement and cash flow statement to get a full picture of a company’s health.
4 important takeaways include:
- Liquidity – Comparing a company’s current assets to its current liabilities provides a picture of liquidity. Current assets should be greater than current liabilities so the company can cover its short-term obligations. The Current Ratio and Quick Ratio are examples of liquidity financial metrics.
- Leverage – Looking at how a company is financed indicates how much leverage it has, which in turn indicates how much financial risk the company is taking. Comparing debt to equity and debt to total capital are common ways of assessing leverage on the balance sheet.
- Efficiency – By using the income statement in connection with the balance sheet it’s possible to assess how efficiently a company uses its assets. For example, dividing revenue into fixed assets produces the Asset Turnover Ratio to indicate how efficiently the company turns assets into revenue. Additionally, the working capital cycle shows how well a company manages its cash in the short term.
- Rates of Return – The balance sheet can be used to evaluate how well a company generates returns. For example, dividing net income into shareholders’ equity produces Return on Equity (ROE), and dividing net income into total assets produces Return on Assets (ROA), and dividing net income into debt plus equity results in Return on Invested Capital (ROIC).
Limitations of Balance Sheets
The balance sheet is an invaluable piece of information for investors and analysts; however, it does have some drawbacks. Since it is just a snapshot in time, it can only use the difference between this point in time and another single point in time in the past. Because it is static, many financial ratios draw on data included in both the balance sheet and the more dynamic income statement and statement of cash flows to paint a fuller picture of what’s going on with a company’s business.
Different accounting systems and ways of dealing with depreciation and inventories will also change the figures posted to a balance sheet. Because of this, managers have some ability to game the numbers to look more favorable. Pay attention to the balance sheet’s footnotes in order to determine which systems are being used in their accounting and to look out for red flags.
What Are the Four Basic Financial Statements?
The balance sheet is one element in a series of four basic financial statements that together give an overview of your business’s financial performance. These are the four basic financial statements and how they’re used to evaluate a business’s finances:
- Balance Sheet: A balance sheet lists a company’s assets, liabilities and shareholders equity at a specific point in time. It’s usually thought of as the second most important financial statement, since it shows the liquidity and the theoretical value of the business.
- Income Statement: A business’s income statement, also called a profit and loss statement, reports the revenues, expenses and profits or losses generated during a specific reporting period. It’s considered to be the most important of the four financial statements because it shows the profits a business is generating.
- Cash Flow Statement: The cash flow statement shows the money flowing into and out of a business during a specific reporting period. The cash flow statement is important to lenders and investors to determine whether a business has access to the cash needed to pay off its debts.
- Statement of Retained Earnings: The statement of retained earnings shows the changes in equity within a business for a specific reporting period. The statement is typically made up of dividend payments, the sale or repurchase of stock and changes resulting from the reporting of profits or losses.
Advantages and Disadvantages of the Balance Sheet
Advantages of Reporting the Balance Sheet
- Business snapshot. Balance Sheet provides an accurate picture of the business status. While the profit and loss statement provides the profit made in a transaction, balance sheet gives the details of the bills the business owes to the vendors. Every balance sheet is unique; while a business may experience a high profit account, it can simultaneously have a poor balance sheet if the total net asset value is low and vice versa. Balance sheet determines the financial strength of a business and helps in future financial planning.
- Provides information for apt decision making. Balance-Sheet provides the investors and potential lenders with the information needed to take decisions while lending money or resources. It reflects the company’s ability to collect and pay debts on time. On the basis of this, one can form an opinion of the company’s risk and return prospects.
- Provides helpful financial ratios. Balance Sheet helps to calculate the ratios to determine a company’s long-term profitability and short-term financial outlook. Ratios like the current ratio and the acid test or liquidity ratio are calculated using information from the balance sheet. These ratios help obtain a very thorough summary of the company’s financial health by analyzing its cash position, working capital, liquidity and leverage. It also provides insight into the company’s likelihood of defaulting on its credit obligations or even its bankruptcy risk.
Disadvantages of the Balance Sheet
- Numbers could be misleading. As the balance-sheet gives the financial snapshot at a given point of time, it could be misleading sometimes. For e.g. the analysis could get distorted if the company’s cash position at year end is high, indicating high reserves, but the company may intend to distribute it in the form of dividends.
- Doesn’t give true value of assets. The balance sheet does not provide the true value of the assets as they are reported at the historical costs. It does not reflect the current market valuation.
- Other limitations. The balance sheet has some of the current assets valued on estimated basis, so it does not reflect the true financial position of the business. Also there is complete omission of the valuable non monetary assets from the balance-sheet.
How to Prepare a Balance Sheet?
Below are the steps mentioned to prepare a balance sheet.
- Compose a trial balance. It is a regular report included in any accounting programme. If it is a manual mode, then create a trial balance by transferring every general ledger account’s ending balance to a spreadsheet.
- Arrange the trial balance. It is important to arrange the initial trial balance to assure that the balance sheet similar to the relevant accounting structure. While using adjusting entries to adjust the trial balance all the entry should be completely recorded so the auditors can understand why it was made.
- Discard all expense and revenue accounts. The trial balance includes expenses, revenue, losses, gains, liabilities, equity, and assets. Delete all from the trial balance except equity, liabilities, and assets. However, the deleted accounts are used to create an income statement.
- Calculate the remaining accounts. In this stage, sum up all the trial balance account used to create a balance sheet. The typical line items used in the balance sheet are:
- Accounts receivable
- Fixed assets
- Other assets
- Accounts payable
- Accrued liabilities
- Other liabilities
- Common stock
- Retained earnings
- Validate the balance sheet. The total for all assets recorded in the balance sheet should be similar to the liabilities and stockholders’ equity accounts.
- Present in the required balance sheet format.