What Is A Balance Sheet? – How To Understand It

What is a Balance Sheet?

A balance sheet is a financial statement that shows a company’s assets, liabilities, and shareholder equity. The balance sheet is one of the three core financial statements used to value a company. It provides a snapshot of a company’s finances (what it owns and owes) as of the date of publication.

Balance sheets provide the basis for computing rates of return for investors and evaluating a company’s capital structure. The balance sheet is key to both financial modeling and accounting. The balance sheet shows the total assets of the company and how the assets are funded, either through debt or equity. It can also be referred to as a statement of net worth or statement of assets. The balance sheet is based on the basic equation: Assets = Liabilities + Equity.

Therefore, the balance sheet is divided into two pages (or sections). The left side of the balance sheet shows all of a company’s assets. On the right side, the balance sheet shows the company’s liabilities and equity.

Assets and liabilities are divided into two categories: current assets/liabilities and non-current assets/liabilities. More liquid accounts such as inventory, cash, and trade payables are placed in the current section before illiquid (or long-term) accounts such as plant, property, and equipment (PP&E) and long-term debt.

Related: What Is An Asset?

What is a Balance Sheet

Why Is a Balance Sheet Important?

A balance sheet provides an overview of a company at a specific point in time. It is a snapshot of a company’s financial position broken down into assets, liabilities, and shareholder equity. Balance sheets serve two very different purposes depending on the audience.

When a balance sheet is reviewed internally by a director, key stakeholder, or employee, it is intended to provide insight into whether a company is successful or not. Based on this information, an internal audience can change their policies and approach: double down on successes, correct mistakes, and turn to new opportunities.

When a balance sheet is externally verified by someone interested in a company, it is intended to provide an indication of the resources available to a company and how they were funded. With this information, potential investors can decide whether it would make sense to invest in a company. It’s also possible to use the information on a balance sheet to calculate key metrics like liquidity, profitability, and leverage.

External auditors, on the other hand, can use a balance sheet to ensure that a company is in compliance with all reporting laws to which it is subject.

It is important to remember that a balance sheet contains information as of a specific date. A balance sheet is always based on historical data. While investors and stakeholders can use a balance sheet to predict future performance, past performance is no guarantee of future results.

Balance Sheet Example

A balance sheet is a financial statement that reports a company’s assets, liabilities, and shareholder equity. The balance sheet is one of the three core financial statements that are used to evaluate a business.

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The image below is an example of a balance sheet from a Corporation from December 2021. You can see there are three sections on the sheet. The assets for the period total $770,000. If you add up the company’s total liabilities ($481,000) and its shareholder equity ($289,000), you get a final total of $770,000—the same as the total assets.

Example of Balance Sheet

Assets

Accounts within this segment are listed from top to bottom in order of their liquidity. This 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 (AR) refer to money that customers owe the company. This may include an allowance for doubtful accounts as some customers may not pay what they owe.
  • Inventory refers to any 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.

Related: What is a Current Asset?

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. These assets are generally 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.

Related: What is a Non-Current Asset?

Liabilities

A liability is any money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds issued to creditors to rent, utilities and salaries. Current liabilities are due within one year and are listed in order of their due date. Long-term liabilities, on the other hand, 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 includes any interest and principal on bonds issued
  • Pension fund liability refers to the money a company is required to pay into its employees’ retirement accounts
  • Deferred tax liability is the amount of taxes that 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.
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Some liabilities are considered off the balance sheet, meaning they do not appear on the balance sheet.

Shareholder Equity

Shareholder equity is the money attributable to the owners of a business or its shareholders. It is also known as net assets since it is equivalent to the total assets of a company minus its liabilities or 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 remaining amount 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.

Does A Balance Sheet Always Balance?

A balance sheet should always balance. The name itself comes from the fact that a company’s assets will equal its liabilities plus any shareholders’ equity that has been issued. If you find that your balance sheet is not truly balancing, it may be caused by one of these culprits:

  • Incomplete or misplaced data
  • Incorrectly entered transactions
  • Errors in currency exchange rates
  • Errors in inventory
  • Miscalculated equity calculations
  • Miscalculated loan amortization or depreciation

How To Prepare a Basic Balance Sheet?

Here are the steps you can follow to create a basic balance sheet for your organization. Even if some or all of the process is automated through the use of an accounting system or software, understanding how a balance sheet is prepared will enable you to spot potential errors so that they can be resolved before they cause lasting damage.

1. Determine the Reporting Date and Period

A balance sheet is meant to depict the total assets, liabilities, and shareholders’ equity of a company on a specific date, typically referred to as the reporting date. Often, the reporting date will be the final day of the reporting period.

Most companies, especially publicly traded ones, will report on a quarterly basis. When this is the case, the reporting date will most usually fall on the final day of the quarter:

  • Q1: March 31
  • Q2: June 30
  • Q3: September 30
  • Q4: December 31

Companies that report on an annual basis will often use December 31st as their reporting date, though they can choose any date.

It’s not uncommon for a balance sheet to take a few weeks to prepare after the reporting period has ended.

2. Identify Your Assets

After you’ve identified your reporting date and period, you’ll need to tally your assets as of that date.

See also :  What are Non-Current Assets?- Their Examples

Typically, a balance sheet will list assets in two ways: As individual line items and then as total assets. Splitting assets into different line items will make it easier for analysts to understand exactly what your assets are and where they came from; tallying them together will be required for final analysis.

Assets will often be split into the following line items:

Current Assets:

  • Cash and cash equivalents
  • Short-term marketable securities
  • Accounts receivable
  • Inventory
  • Other current assets

Non-current Assets:

  • Long-term marketable securities
  • Property
  • Goodwill
  • Intangible assets
  • Other non-current assets

Current and non-current assets should both be subtotaled, and then totaled together.

3. Identify Your Liabilities

Similarly, you will need to identify your liabilities. Again, these should be organized into both line items and totals, as below:

Current Liabilities:

  • Accounts payable
  • Accrued expenses
  • Deferred revenue
  • Current portion of long-term debt
  • Other current liabilities

Non-Current Liabilities:

  • Deferred revenue (non-current)
  • Long-term lease obligations
  • Long-term debt
  • Other non-current liabilities

As with assets, these should be both subtotaled and then totaled together.

4. Calculate Shareholders’ Equity

If a company or organization is privately held by a single owner, then shareholders’ equity will generally be pretty straightforward. If it’s publicly held, this calculation may become more complicated depending on the various types of stock issued.

Common line items found in this section of the balance sheet include:

  • Common stock
  • Preferred stock
  • Treasury stock
  • Retained earnings

5. Add Total Liabilities to Total Shareholders’ Equity and Compare to Assets

To ensure the balance sheet is balanced, it will be necessary to compare total assets against total liabilities plus equity. To do this, you’ll need to add liabilities and shareholders’ equity together.

If you’ve found that the balance sheet doesn’t balance, there’s likely a problem with some of the accounting data you’ve relied on. Double-check that all of your entries are, in fact, correct and accurate. You may have omitted or duplicated assets, liabilities, or equity, or miscalculated your totals.

A Crucial Understanding

The information found in a company’s balance sheet is among some of the most important for a business leader, regulator, or potential investor to understand. Without this knowledge, it can be challenging to know whether a company is struggling or thriving, highlighting why learning how to read and understand a balance sheet is a crucial skill for anyone interested in business.