What Is a Balance Sheet and How its work?
What Is A Balance Sheet?
The term balance sheet refers to a financial statement that reports a company’s assets, liabilities, and shareholder equity at a particular point in time. Balance sheets provide the basis for investors to calculate rates of return and assess a company’s capital structure.
In short, a balance sheet is a financial statement that provides a snapshot of a company’s assets and liabilities, as well as the amount invested by shareholders. Balance sheets can be used in conjunction with other important financial statements to perform fundamental analysis or calculate financial ratios.
The balance sheet is one of the three primary financial statements used to evaluate a business.
Provides a snapshot of a company’s finances (its assets and liabilities) as of the date of publication.
The balance sheet adheres to a parity equation of assets with liabilities and shareholders’ equity.
How Do Balance Sheet Work?
The balance sheet provides an overview of a company’s financial condition at a particular point in time. It cannot sense long-term trends on its own. For this reason, the balance sheet should be compared to previous periods.
Investors can get a sense of a company’s financial well-being using a number of ratios that can be derived from the balance sheet, including the debt-to-equity ratio and the acid test ratio, among 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 supplements on the income statement that refer to the balance sheet.
The balance sheet adheres to the following accounting equation, with assets on the one hand, and shareholders’ equity, plus liabilities, on the other hand, to balance:
This formula is intuitive. This is because the company must pay for all the things (assets) it owns either by borrowing (taking on liabilities) or from investors (issuing equity).
If a company gets a 5-year loan of $4,000 from a bank, its assets will increase by $4,000. Its liabilities (specifically, the long-term debt account) will increase by $4,000, balancing both sides of the equation. If the company borrows $8,000 from investors, its assets will increase by that amount, as will shareholders’ equity. All revenues generated by the company in excess of its expenditures will go to the shareholders’ equity account. This revenue will be offset by assets shown as cash, investments, stock or other assets.
Important: Balance sheets should also be compared to other companies in the same industry because different industries have unique approaches to financing.
As mentioned above, you can find information about assets, liabilities, and shareholder’s equity on a company’s balance sheet. Assets must always equal liabilities and shareholders’ equity. If they don’t balance, there could be problems, including inaccurate or incorrect data, inventory or exchange rate errors, or miscalculations.
Each category contains many sub-accounts that detail the company’s financial details but there are some common components that investors are likely to encounter.
Components Of The Balance Sheet
Accounts under this category are listed in order of liquidity from top to bottom. This is the ease with which it can be converted into cash. It is divided into current assets that can be converted into cash within a year or less. And non-current or long-term assets, which can not.
The general arrangement of accounts within current assets is:
Cash and cash equivalents are among the most liquid assets and can include treasury bills, short-term certificates of deposit, as well as hard currencies.
Accounts receivable (AR) refers to the amount customers owe the company. This may include a provision for doubtful accounts because some customers may not pay their dues.
Inventory refers to any goods available for sale at cost or market value, whichever is lower.
Long-term assets include:
Long-term investments are securities that will or will not expire in the next year.
Fixed assets include land, machinery and equipment, buildings and other durable assets that are usually capitalized.
Intangible assets are usually only recorded on the balance sheet if they are purchased rather than produced in-house. Its value can thus be greatly underestimated (for example by not including a universally recognized logo) or greatly overestimated.
A liability is any amount a business owes to outside parties, from bills it has to pay suppliers for rent, utilities, and salaries to interest on bonds issued to creditors. Current liabilities are due within one year and are recorded on their due date. On the other hand, long-term liabilities are due at any time after one year.
Current Liability Accounts May Include:
The current portion of long-term debt is the portion of long-term debt that is due within the next 12 months. For example, if a company has 10 years remaining on a loan to pay off a warehouse, then 1 year is a current liability and 9 years is a long-term liability.
Accrued interest is the interest owed, often as part of a late payment liability such as late payments on property taxes.
Payments are salaries, wages, and benefits for employees, often for the latest pay period.
A customer prepayment is money that a customer receives before a service is provided or a product is delivered. The Company is obligated to (a) supply the Goods or Services or (b) refund the money to the Customer.
Dividends payable are dividends that are authorized to be paid but not yet issued.
Earned and unearned premiums are similar to advance payments in that the company has already received money, has not performed their part of the contract, and is not earned if they fail to perform. Money must be returned.
Accounts payable is often a general current obligation. Accounts payable are debt obligations on invoices processed as part of business operations that are often due within 30 days of receipt.
Long-Term Liabilities May Include:
Long-term debt includes any interest and principal on the bonds issued.
The pension fund liability refers to the amount that the company has to pay into the retirement accounts of its employees.
The deferred tax liability is the amount of taxes that are due but will not be paid until another year. In addition to timing, this number reconciles differences between financial reporting requirements and tax estimation methods, such as depreciation calculations.
Some liabilities are off-balance sheet, which means they don’t appear on the balance sheet.
Equity is money that is attributed to the owners or shareholders of a business. It is also known as net assets because it equals the company’s total assets minus its liabilities or debts owed to non-shareholders.
Treasury shares are shares that a company has bought back. It can be sold at a later time to raise cash or held in reserve to fend off a hostile takeover.
Preferred shares are assigned an arbitrary par value (as are common shares, in some cases) which does not affect the market value of the shares.
Additional paid-in capital or capital surplus represents the amount shareholders have invested in excess of common or preferred stock accounts, which are based on face value rather than market value. Shareholders’ equity is not directly related to the company’s market value. The latter is based on the current price of the stock, while paid-in capital is the sum of the equity purchased at any price.