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Balance Sheet

Preparation of Balance Sheet

A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders.

The balance sheet is used alongside other important financial statements such as the income statement and statement of cash flows in conducting fundamental analysis or calculating financial ratios.

An Introduction To The Balance Sheet
Formula Used for a Balance Sheet

The balance sheet adheres to the following accounting equation, where assets on one side, and liabilities plus shareholders' equity on the other, balance out:

\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}Assets=Liabilities+Shareholders’ Equity

This formula is intuitive: a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholders' equity).

For example, if a company takes out a five-year, $4,000 loan from a bank, its assets (specifically, the cash account) will increase by $4,000. Its liabilities (specifically, the long-term debt account) will also increase by $4,000, balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholders' equity. All revenues the company generates in excess of its expenses will go into the shareholders' equity account. These revenues will be balanced on the assets side, appearing as cash, investments, inventory, or some other asset.

Assets, liabilities and shareholders' equity each consist of several smaller accounts that break down the specifics of a company's finances. These accounts vary widely by industry, and the same terms can have different implications depending on the nature of the business. Broadly, however, there are a few common components investors are likely to come across.

What's On the Balance Sheet?

The balance sheet is a snapshot representing the state of a company's finances at a moment in time. By itself, it cannot give a sense of the trends that are playing out over a longer period. For this reason, the balance sheet should be compared with those of previous periods. It should also be compared with those of other businesses in the same industry since different industries have unique approaches to financing.

A number of ratios can be derived from the balance sheet, helping investors get a sense of how healthy a company is. These include the debt-to-equity ratio and the acid-test ratio, along with many others. The income statement and statement of cash flows also provide valuable context for assessing a company's finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet.

Assets

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

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.

What Are the Benefits of Balance Sheets?

  • It Determines Risk and Return
  • A balance sheet succinctly lists your assets and liabilities in one place. Current and long-term assets reflect your ability to generate cash and sustain operations. In comparison, short- and long-term debts prioritize your business’s financial obligations. Ideally, you have more assets on your balance sheet than liabilities, indicating positive net worth.

    Comparing your current assets to current liabilities determines whether your business can cover its short-term obligations. If your current liabilities exceed your cash balance, your business may require additional working capital from outside sources. However, a balance sheet can also show you when your debt levels are unsustainable. If you have too much debt on your balance sheet, you may default on debt payments or declare bankruptcy.

  • It Can Be Used to Secure Loans and Other Capital
  • Your balance sheet allows people outside of your company to quickly understand its financial condition. Most lenders require a balance sheet to determine a business’s financial health and creditworthiness. Additionally, potential investors may use it to understand where their funding will go and when they can expect to be repaid.

    When updated over time, your balance sheet effectively shows your ability to collect payments and repay debts. Plus, it shows lenders that you have a track record of managing assets and liabilities responsibly. If you apply for a loan, it will also show lenders that you’ll likely repay your debts in a timely manner.

  • It Provides Helpful Ratios
  • Ratios are often used in financial statement analysis to indicate a company’s operational efficiency, liquidity, profitability, and solvency. These financial ratios are particularly helpful when assessing the long-term sustainability of a business. They can be determined by a company’s balance sheet accounts.

    For example, your balance sheet is a snapshot that reveals your company’s overall capital structure. It can also tell you how long it takes to sell inventory and the length of your accounts receivable process. This information can help you identify trends and see how your company’s finances and operations compare to competitors.