A balance sheet is a snapshot of a company’s financial situation. It is a financial statement that summarizes the company’s assets, liabilities, and equity at a specific time. Along with income statements and cash flow information, it is also a vital business component.
Key Takeaways
- A balance sheet is a financial reporting statement that provides the details of assets, liabilities, and equity.
- The balance sheet follows the general equation of Assets = Liabilities + Shareholder’s equity.
- Assets, liabilities, and shareholder’s equity can be classified into subtypes like current and non-current.
The balance sheet can be classified, unclassified, comparative, or vertical format.
- Analyze the balance sheet by identifying key metrics, ratios, strengths, weaknesses & red flags.
- Balance sheets help you to plan business finances by forecasting and scenario planning
- It has some limitations such as being time-fixed, historical data based, and limited information on intangible assets.
What is a Balance sheet
The balance sheet is a financial report detailing a company’s assets, liabilities, and reports in a specific period. This gives a clear-cut example of what you own and owe. Depending on the specific accounting period, a balance sheet can be prepared monthly, quarterly, and annually.
But why is this simple sheet so important? This statement speaks for your company’s financial health, on which banks and investors rely. With this, anyone can easily evaluate the capital structure of the business. This clarifies if the business has sufficient funds to invest in operations and understand its operation.
Of course, like other financial data, the balance sheet is also linked with the income statements and cash flow reports. These two have a cumulative effect on the balance sheets and can be observed through changes in the sheets. For example, if the profit is increased in the income statement, the retained earnings are also increased.
Example of a Balance Sheet
Sample Balance Sheet for a Hypothetical Company
Format
A balance sheet can be prepared in two formats – horizontal and vertical.
Vertical: In the vertical formats, the assets, liabilities, and shareholder’s equity are categorized one after another.
Horizontal: The assets are shown on the right-hand side, and the other two are on the left.
Key Figures of Amounts
For a hypothetical company, let’s assume Company X. Some of the key amounts that need to be included in the balance sheet are –
- Current Assets – $ 202, 205
- Non-current Assets – $ 198, 000
- Other assets – $ 16,000
- Current Liabilities – $60,000
- Long term Liabilities – $ 49,000
- Retained Earrings – $48,000
- Capital- $259,205
Explanation of each line item
Current vs. Non-current Assets: Current assets, as the name suggests, are expected to be sold in the current period, like in a year. However, non-current assets are the long-term assets that are expected to be used for a longer period. For example, accounts receivable and inventory, respectively.
Current vs. Long-term Liabilities: Liabilities that are paid within 12 months are current liabilities (short-term debts), whereas long-term liabilities are paid beyond this term (long-term debts).
Owner’s Equity components: Retained earnings and capital are the components of the owner’s equity. It can be calculated by subtracting liabilities from the assets.
Visual representation of the balance sheet
Purpose of a Balance Sheet
The balance sheet is useful for identifying financial conditions, helps in financial management, and helps in critical business decisions. It also attracts stakeholders and enables them to access the company’s value.
- Financial Management: As cited by Marta Noscova in her research, financial analysis can influence financial management and business competitiveness. The balance sheet shows how your business can overcome its financial obligations, pay off its debts, and distribute the funds.
- Overview Financial Health: It presents how much a company has in its hands, how much it will retain, and how much will be available soon.
- A tool for stakeholders: The balance sheet works as a document that helps stakeholders, especially managers, investors, and creditors to evaluate and decide if the company is worth investing in.
- Helps in decision-making: As the balance sheet lays the in-out financial data, it helps the investors make decisions. It also helps your company design and fine-tune your business financial strategies by following the trends and ratios.
- Compliance with regulatory requirements: These sheets are often compliant with regulatory practices. The most common of them are GAAP and IFRS. These differentiate the categorical orders, liquidity, and disclosures in specific methods.
Components of a Balance Sheet
A balance sheet is divided into three main sections: assets, liabilities, and shareholders’ equity. Together, these sections reveal the resources a company controls, the obligations.
Assets
Assets are the resources that have monetary value needed to run the business. It generates cash flow, reduces expenses, and improves sales. Based on the format, they can be listed on the top or left side.
Assets can be classified into two distinct types – current and noncurrent.
1. Current assets: Current assets are that can be easily converted into cash within one year. The common examples of the current assets are –
- Cash: This is the liquid assets and might also include treasury bills and deposits
- Accounts receivable: The amount that the customers owe and would be paid to the company.
- Inventory: Goods that are stocked for sale.
- Prepaid expenses: Expenses related to insurance, marketing, etc., are also termed as assets.
2. Non-current assets: Non-current assets are assets that provide long-term benefits and are not expected to sell within a year.
- Property: Land or property is the fixed assets used for long-term or permanent use.
- Equipment: Machinery or technical instruments are non-current assets not liquidated soon.
- Intangible assets: Non-physical assets that are generally omitted or understated in the balance sheet like patents, trademarks.
Goodwill: The value of a company’s reputation or brand
Role of Liquid and Intangible Assets
These current or mainly termed liquid assets are used for the immediate financial expense of the business. Primarily, they are used for operating expenses or mitigating any unforeseen events.
High liquid assets mean your company can meet short-term debts flexibly. On the other hand, intangible assets are non-physical ones used for long-term business needs like improving customer relations. They are often valued by the cash flows of assets and non-assets.
Liabilities
To put it simply, liabilities are the debts that are owed by the companies. It refers to what the company borrows instead of what it owns. It is one of the key components that help identify a company’s financial condition. Liabilities encompass both current and long-term liabilities.
1. Current liabilities: These liabilities are paid within a year.
- Accounts payable: Debts that are part of the operations invoices and mostly cleared in 30 days.
- Short-term loans: Loans taken for a shorter time to meet the demands or sudden events.
- Accrued expense: Expenses incurred but not yet paid for, like monthly goods or services payments.
2. Non-current liabilities: Liabilities often have a long time frame, usually more than a year.
- Long-term liabilities: Long-term liabilities are debts paid for on a long-term basis, like mortgages.
- Deferred tax liabilities: Taxes that have already been incurred but payment will be made in the next year.
Impact of liabilities on financial health
Liability does not only impact the balance sheet but also business operations. It limits the cash and interrupts operational activities, like ordering supplies & equipment and completing day-to-day work.
It hampers liquidity and short-term resources, affecting operational expenses such as supplier payments. It affects the company’s solvency as well as hurts the perception of investors and lenders.
Shareholders' Equity
Shareholder’s Equity (SE) is the company’s net asset as it minuses liabilities from the total assets. It consists of capital plus company-retained earnings. Similar to assets and liabilities, shareholder’s equity is also a key metric used to analyze a company’s financial health.
The components of the shareholder’s equity are –
1. Paid-in Capital: Amount of money a company generates by selling common and preferred stocks.
- Common Stock: Common Stock is the partial ownership of the company. The balance sheet represents the total amount gained from the investors. Their dividends are not guaranteed.
- Preferred Stock: This stock gives the investor an equity security. Preferred shareholders usually receive fixed dividends.
2. Retained Earnings: The net or actual income of the company that is generated after paying all the costs, taxes, and dividends.
3. Treasury Stock: Treasury Stock is the shares that are repurchased by the company from the open market. Often, it is mentioned in the negative numbers in the shareholder’s equity section.
How shareholders' equity reflects company value
Basically, shareholder’s equity (SE) represents the money the company will have after using all assets and paying off debts. The positive SE depicts the company has enough assets to cover its liabilities. This means the company is financially solvent and stable. In turn, investors are more interested in their equity, which makes the company more valuable in the market.
The opposite happens when the SE value is negative on the balance sheet. This implies that the company is unable to meet its liabilities and is prone to financial hurdles. That’s the biggest turn-off for the investors, as well.
The Balance Sheet Equation
The balance sheet is based on the basic accounting equation. As quoted by accounting professionals in HBS. The sum of the shareholders’ equity and liabilities always equals the total assets.
Assets = Liabilities + Shareholder’s equity
As the name suggests, the balance sheet must be balanced with each transaction. The equation shows that every company asset is financed through either debt or equity. When a company acquires more assets, its liabilities or shareholders’ equity also increase to keep the balance. Conversely, If liabilities increase, assets must grow or equity must decrease.
For example, when a company buys equipment of $12,000, it increases the asset field by $12,000. However, it also decreases the ‘cash’ by $12,000, ensuring proper balance. Again, if a company takes out a loan, assets (cash) increase, and liabilities (loans payable) increase.
This equation shows the simplistic relationship of the resources or assets that are either claimed or owned. When you understand this connection, you can clarify how a company finances its assets. Ultimately, you can evaluate the company’s financial risk and stability through debt.
Balance Sheet Formats
Balance sheets can be of different formats and styles. Based on the purpose and reporting needs, the balance sheets can be categorized into various types. Let’s break them down for better understanding.
Classified Balance Sheet
A classified balance sheet provides a detailed breakdown of assets, liabilities, and equity. This format does not have any set of rules. The breakdowns of assets, liabilities, and equities into sub-categorieslike current and non-current give the entire company picture. Thus, it is mostly used by large companies for detailed financial reporting.
Unclassified Balance Sheet
This type of balance sheet is unsorted, like its name. It does not categorize assets, liabilities, and other information in detailed sections. It is a simpler version, more like rough data.
Here’s the catch. The uncategorized sheet does not mean it contains less data than classified ones. Rather, it includes the same data, just in unsorted form. Most of the time, it is organized in order of liquidity. Unlike classified sheets, unclassified ones are quite useful for small businesses.
Comparative Balance Sheet
The comparative balance sheet is based on a simple financial comparison of multiple periods. Usually, in this format, the financial reporting is compared to two subsequent fiscal years. This helps to gauge the financial stability at the end.
This can be done with more than two years also. As it compares the two reporting periods side-by-side, it enables the business owners to assess the trends. They can easily understand the seasonal demands and fluctuations of the companies.
Vertical Balance Sheet
Vertical balance sheets list the assets, liabilities, and shareholder’s equity one after another in a single column. In each category, sub-categories are ordered in decreased rates of liquidity.
The main purpose of this format is simplicity. It makes it easier to read and interpret the data. It also makes it clean enough to compare with the other income statements and different fiscal years.
How to Analyze a Balance Sheet
A balance sheet can only be useful when you know how to analyze it properly. First of all, you need to know the key metrics and ratios that need to be studied. Moreover, it also has some strengths, weaknesses, and limitations, which you need to know in order to properly study.
Key Financial Ratios Derived from the Balance Sheet
Liquidity Ratios
This financial ratio measures the company’s ability to repay short-term debts by comparing assets and liabilities.
- Current ratio: The ratio between the current assets and the current liabilities is the current ratio. The ratio must need to be greater than 1 for a financially stable company.
- Quick ratio: In quick ratio (or acid test), inventories are subtracted from the current assets. It is then compared with the current liabilities.
Liquidity is an essential factor that determines a business’s solvency. The ratio of liquidity greater than 1 implies the company has sufficient liquidity. Therefore, the company can finance its short-term debts and obligations. This may include paying rent and payrolls. And, all this without cash flow disruption for daily business operations.
Leverage Ratios
Leverage ratios indicate how much a company relies on its debt to finance its operation. This can be divided into two more ratios – debt-to-equity and debt ratio.
- Debt-to-equity ratio: It is the ratio between the liabilities and the shareholder’s equity. The higher the debt-to-equity ratio, the less stable the company is.
- Debt ratio: Commonly known as debt-to-asset ratio, it is the ratio between the total liabilities and assets. A ratio of 1 indicates that the loan is financed by equity.
As these ratios tell how much debt a company uses, it indicates its financial risk. When the ratios are higher, the company’s risk is also greater. This data helps the lenders and investors by exposing the company’s actual financial risk.
Efficiency Ratios
The efficiency ratio measures how efficiently the resources are used to generate income. Asset turnover ratio and inventory ratio are some of the key metrics under this.
Asset turnover ratio: It measures how much assets are used to generate revenues efficiently. You can get this by dividing net sales by the total assets.
Inventory turnover: Inventory turnover rates show how quickly a company sells and replaces its inventory. It is calculated by dividing the cost of goods by inventory.
Profitability Ratios
Profitability ratios are the ratio of the profit a company generates from the assets and equity.
- Return on assets (ROA): The division between the net income and total assets gives the ROA. It is actually the revenue generated from the assets.
- Return on equity (ROE): ROE measures how much profit a company generates from its shareholder’s equity. It is done by dividing net income by total equity.
ROA and ROE ratios are the main components to measure a company’s performance. The value of these ratios indicates the trend and the company’s future growth. As a result, it adds up to the balance sheet data to understand and predict financial stability.
Identifying Strengths and Weaknesses
Apart from the key metrics, you must also interpret the balance sheet for strengths and weaknesses. Large amounts of cash, accounts receivable, and investments suggest a solid asset base.
However, the situation is quite different when the liabilities are high. You can understand this easily by noticing the long-term and short-term debt values. When a company’s liabilities exceed that of its assets, its working process is affected. Also, this shows how a company is over-dependent upon the debts for business operations.
Likewise, the value of equity also helps to determine the business’s resilience and weak points. For example, high equity means a company is resilient to deal with sudden financial issues. It can easily invest in better opportunities and scale. While the low value means the business cannot cushion against future demands when profit is declining.
Red flags on a balance sheet
Looking between the values is the key to understanding the balance sheets. The central part is knowing the red flags. You can save your business by solving those red flags on a balance sheet.
- Negative Retained Earnings: This means the company is facing consistent losses and can’t reinvest.
- Excessive Debt: The company can become bankrupt if debt levels are higher than equity and assets.
- Decreasing Current Assets: Decreasing current assets without any change in liability reduces liquidity, and the company can’t meet its short-term obligation.
- Less Inventory Turnover: Less inventory items are sold, and the business is unproductive and unprofitable.
- Overstated Financial Reporting: Assets are not correctly valued and provide misleading financial information.
- Greater Intangible assets: Indicates inflated valuations and overestimates brand values, which are far from reality.
Common Balance Sheet Adjustments and Errors
Although the balance sheet provides insightful data, a simple error can mislead the entire business plan. Sadly, there are always some human errors. To solve this, you need to understand the revaluation, find mistakes in reporting, and do proper audits.
Revaluations
The value of the assets changes over time. Thus, revaluation is essentially needed to avoid misinformation. One of the significant adjustments is required in depreciation and amortization. Depreciation is the degrading value of tangible assets (like equipment).
At the same time, amortization is the degrading value of intangible assets (like patents). These adjustments are necessary to show the actual value of the balance sheet. Neglecting this can give misleading information about profit margins and assets.
Asset revaluation is needed as values often fall below the current amount. This eventually leads to impairment loss. To avoid complexities, these values need to be noted in financial statements. All this helps to portray the real economic value of the company.
Errors in Reporting
Errors in balance sheets are pretty common. Numbers can speak, but wrong numbers can destroy your company. Overstating the assets while understating the liabilities is something that many businesses face. A mistake would be an understatement; this is a major accounting fraud. This simple change of data can give false insights like –
- Make the company look financially stable
- Higher net income
- Can lend more money
- Shows increased equity and net worth
Another top reporting problem is omission and double counting. It is the biggest mistake on the balance sheet and can flip all the necessary valuations. This data makes the company look better or worse – either way, this does not give you the real information.
Audits and internal controls
Proper audit and internal control are necessary to avoid reporting errors and revaluation issues. The following steps can be maintained to solve error-prone data and fraud values.
- A proper framework for monitoring and overseeing financial activities.
- Set guidelines to meet compliance laws and international standards.
- Distribute the duties of accounting, recordkeeping, and calculation to different members.
- Limit access to sensitive data and control them efficiently.
- Perform risk assessment regularly and double-check the data.
- Communicate & report the issues and take measures to solve them timely.
Business Activities on the Balance Sheet
Each and every business activity has an equal reaction on the balance sheet. Either you take a loan or buy a property – there’s always an impact. From simple transactions to mergers & acquisitions, you must dive deeper into the stats to understand this.
How Common Business Transactions Affect the Balance Sheet
Not all business transactions are directly recorded on the balance sheet. But there is always an effect on the numbers on the sheet. It can be asset fluctuation, liability decline, and even equity rate change.
- Borrowing funds: Though borrowing funds is a simple transaction, it can increase liabilities on the balance sheet. Eventually, this will decrease the net income and the cash flow. With this, the debt-to-asset ratio increases, which makes the company look riskier.
- Acquisition of new assets: When a company buys a new asset, it increases the asset section. Along with it, the cash account goes down as it is used to buy the asset. Overall, the balance sheet remains balanced as before.
- Stock issuance or repurchase: Stock repurchase or issuance not only decreases the total asset & cash amount but also equity. However, doing this can increase Treasury Stock by the cost of the shares.
- Paying off debts: As you know, paying the debts reduces your short and long-term obligations. Therefore, the liabilities of the balance sheet decrease. As a result, the company’s equity also increases, positioning it in a more stable condition.
Mergers, Acquisitions, and Their Effects on the Balance Sheet
When a company goes through a merger and acquisition (M&A) scheme, its balance sheet changes significantly. Usually, in acquisitions, a company buys another company or asset. When the asset value exceeds the market value, a ‘goodwill’ value is added to the balance sheet. Consequently, this increases the net assets.
On the flip side, the merger is different. A merger is when two companies combine together. When such changes occur, the assets and liabilities are consolidated. Both the financial statements are combined, and the assets, liabilities & equity are changed.
Balance Sheet Under Different Accounting Standards
According to accounting standards, the balance sheet can be different. Based on accounting laws like GAAP and IFRS and industry-specific needs, you can prepare different types of balance sheets.
Balance Sheet Under Different Accounting Standards
| Aspect | GAAP | IFRS |
|---|---|---|
| Definition | GAAP, or Generally Accepted Accounting Principles, are standard accounting rules followed in financial reporting. | IFRS stands for International Financial Reporting Standards, which determine how the data should be presented |
| Format of Balance Sheet | No specific format, but mostly ordered according to the liquidity rates. | Requires classified balance sheet starting from non-current assets, followed by current assets, equity & liability. |
| Valuation of Assets | Recorded at historical cost | Recorded at either historical or fair value |
| Recognition of liabilities | Recorded when the liabilities are probable | Recorded when obligations are arising, and outflow of assets is required |
| Equity | Divided into common stock, retained earnings, additional paid-in capital, and others | Divided into share capital, share premium, retained earnings, and revaluations |
| Goodwill | It is amortized | |
| Fixed Asset | Revaluation can be done | Revaluation can’t be done |
Industry-Specific Balance Sheets
Based on different industries, balance sheets also differ from each other. Mainly, it varies because financial reporting can vary according to the operations, risks, and regulations. For example, banks, insurance, and manufacturing firms all have unique financial reporting forms. Banks often prefer balance sheets rich in details about assets and liabilities.
But, the insurance companies do not like that format. They focus more on liabilities. Again, a manufacturing company does not follow any of these. Instead, its main goal is to record the tangible assets more closely.
Thus, tailoring balance sheets is severely important. Some industries are more interested in liquidity, and others are in debt. Also, several other sectors are interested in neither but only physical goods and production. For this reason, you need to know how to customize the balance sheets by industry norms. This would allow the stakeholders and inventors to assess and compare the financial data more flexibly.
Balance Sheet and Financial Planning
The balance sheet is not just numbers. Proper interpretation of the balance sheet can help to plan future finances of businesses. By forecasting and budgeting, you can create different scenarios to plan overhead.
Balance Sheets in Forecasting and Budgeting
Balance sheets are often the best solution for forecasting financial needs. When you analyze the values properly, you can see what assets are currently processed and what liabilities they hold. With this, it becomes easier to determine future needs for assets. You can also decide if you need more loans or can finance the debts.
You can also observe equity values. They reveal a lot about the company’s position in the industry. By studying them, you can quickly understand the changes in equity. Thus, you can plan the dividends accordingly.
Scenario Planning
Often, businesses rely on balance sheets for scenario analysis. In this analysis, companies make assumptions and plan the financial outcomes beforehand. This helps them to take more right steps and make informed decisions in every condition.
By adjusting the key values, businesses often make two assumptions – best case and worst case.
- Best Case: Here, companies assume optimistic financial reporting such as more liquidity, profit, improved asset utilization, and suitable market trends.
- They can plan project growth to expand their business without taking loans.
- Forecast increased return of assets and shareholder’s values.
- Plan how to optimize capital or asset allocation for reinvestment and dividends.
- Worst Case: Opposite of best case. It assumes less liquidity, high debt, less turnover, and economic problems.
- Assess how long they can meet their obligations with the liquidity.
- The process of managing debt and finding refinancing options.
- Identify which assets can be sold to liquidate the cash in extreme situations.
Limitations of the Balance Sheet
Even though a balance sheet is an invaluable asset, it is not the complete solution. It, too, has some major limitations. It’s time-specific nature, along with historical analysis and off-sheet data, is something that you won’t be pleased with.
Time-Specific Nature
The balance sheets are often recorded at a limited time scale. They do not provide you with the long-term financial reporting. Often, you get one-month or year values, limiting the chance of doing a comparative analysis.
Besides, it is not future-oriented. That means it does not show you the future cash flows. Thus, it limits your option to predict future performance. Apart from this, you can’t also understand the impact on the cash flow when you change one variable. However, you can defeat this issue by using the accounting features of financial software. Try Financfy and easily solve this drawback.
Historical Cost Basis
Another major problem is the nature of balance sheet reporting is based on historical cost. Historical costs often do not reflect the current market values. Therefore, it does not provide many helpful insights. This data is mainly static and does not contain any readjustments. All these significantly make it hard to understand the actual financial conditions.
Intangible Assets and Off-Balance Sheet Items
Even after trying hard, the actual valuations can never be on the balance sheets. This happens due to the intangible assets. Measuring physical assets is straightforward, but assessing intangible assets is more challenging. Brand awareness, customer loyalty, and even intellectual property can’t be tracked easily like tangible ones. Thus, this value is often not properly included.
That’s not all. Off-balance sheet items like leases, letters of credit, and loan commitments also limit you to identify the company’s actual value. Ultimately, this affects the transparency of the balance sheet and creates grounds for confusion.
Conclusion
The balance sheet is an important component of business, just like any other financial statement. It provides detailed information about the company from assets, liabilities, and equity. As it breaks down each of these into more understandable sub-categories, recording and monitoring the performance becomes easier. Based on these values, investors, creditors, and even business owners can determine a company’s financial stability.
However, these sheets can also contain errors and not always provide the right insights. To avoid these issues, you just need to review their balance sheets regularly. Along with it, you will also need to analyze the sheet for proper budgeting plans and future growth. Only then can you raise your company to the heights of success.
FAQs
What is the difference between a balance sheet and an income statement?
A balance sheet shows a financial report of assets, liabilities, and equity at an exact point in time. Conversely, the income statement presents revenue, expense, net income, and profit data.
How often should a company prepare a balance sheet?
Depending on the needs of the business, a company can prepare a balance sheet annually, quarterly, or even monthly. However, the general practice is to create the sheet quarterly.
Why might a balance sheet show negative equity?
A negative equity value is generated when the liabilities exceed the amount of assets. This can occur due to consistent losses, excess dividend payments, or loans.
How can I use a balance sheet to make investment decisions?
Study the values of assets, working capital, and short-term liquidity. Also, note the capitalization structure properly if you want to make proper investment decisions.
What are the warning signs of financial trouble on a balance sheet?
On a balance sheet, some warning signs of financial trouble are high debt levels, negative cash flow, and low profit margins. Also, the common thing you will notice is that liabilities will increase more than assets.
