What Is a 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.
- A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity.
- The balance sheet is one of the three (income statement and statement of cash flows being the other two) core financial statements used to evaluate a business.
- The balance sheet is a snapshot, representing the state of a company's finances (what it owns and owes) as of the date of publication.
- Fundamental analysts use balance sheets, in conjunction with other financial statements, to calculate 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:
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.
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
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.
Learn More About Balance Sheets
The balance sheet is an important document for investors and analysts alike.
Frequently Asked Questions
What is the balance sheet used for?
The balance sheet is an essential tool used by executives, investors, analysts, and regulators to understand the current financial health of a business. It is generally used alongside the two other types of financial statements: the income statement and the cashflow statement. Balance sheets allow the user to get an at-a-glance view of the assets and liabilities of the company. The balance sheet can help users answer questions such as whether the company has a positive net worth, whether it has enough cash and short-term assets to cover its obligations, and whether the company is highly indebted relative to its peers.
What is included in the balance sheet?
The balance sheet includes information about a company’s assets and liabilities. Depending on the company, this might include short-term assets, such as cash and accounts receivable; or long-term assets such as property, plant, and equipment (PP&E). Likewise, its liabilities might include short-term obligations such as accounts payable and wages payable, or long-term liabilities such as bank loans and other debt obligations.
Who prepares the balance sheet?
Depending on the company, different parties might be responsible for preparing the balance sheet. For small privately-held businesses, the balance sheet might be prepared by the owner or by a company bookkeeper. For mid-size private firms, they might be prepared internally and then looked over by an external accountant. Public companies, on the other hand, are required to obtain external audits by public accountants, and must also ensure that their books are kept to a much higher standard. Public companies’ balance sheets and other financial statements must be prepared in accordance with Generally Accepted Accounting Principles (GAAP), and must be filed regularly with the Securities and Exchange Commission (SEC).