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A balance sheet is a fundamental financial statement that provides a snapshot of a company’s financial health at a specific point in time
In this article, we’re going to talk about the balance sheet – one of the three fundamental financial statements used by businesses and professionals around the world. We’re going to explore what the balance sheet represents, why it is so important, and dive deeper into its individual components.
What is a balance sheet?
A balance sheet, like we noted earlier, is one of the three fundamental financial statements used to depict the intrinsic health of a company. The three statements are:
- The Income Statement or the Statement of Profit and Loss
- The Balance Sheet or the Statement of Financial Position
- The Cash Flow Statement
The balance sheet can be thought of like a photograph of what a company owns (assets), owes (liabilities), and the amount invested by its owners (equity) on a particular date.
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Components of a typical balance sheet
A typical balance sheet is divided into two main sections: Assets, and Liabilities & Equity.
Assets
These are resources that are owned by the company that hold economic value. They can be categorised as:
- Current assets: Current assets are assets that can be expected to be converted to cash within a year. They include cash itself, accounts receivable (money that is owed to the company for products or services), inventory, prepaid expenses, etc.
- Non-current assets: These are assets that can’t usually be converted to cash within a year. They’re also called long-term assets. These include: long-term investments, property, plant & equipment, intangible assets (like patents), etc.
Liabilities and equity
These represent the sources of financing the company’s assets. Let’s understand each of these components individually:
This is the debt that the company has taken on and now owes to someone else. These can be further classified into current and non-current liabilities, which, like assets, depend on whether they are due within a year or not.
Current liabilities usually include debts like accounts payable, accrued expenses, short-term loans, while non-current liabilities include debts like mortgages, bonds, etc.
Also known as shareholder’s equity, this is the amount of money that is invested into the company by its owners. This includes share capital, which is the money the company raises by issuing new shares, and retained earnings, which is a sum of the profits accumulated by the company over time that have not been distributed as dividends.
The balance sheet equation
A fundamental principle of accounting is reflected in the balance sheet equation:
Assets = Liabilities + Shareholders’ Equity
This equation ensures that the total value of the company’s assets is always equal to the total amount financed by its liabilities and shareholders’ equity.
Importance of the balance sheet
The balance sheet is a very crucial document for a company’s stakeholders, including investors, creditors, and the management.
The main purpose of this document is to reveal the company’s financial position to its stakeholders by showing how its assets are being financed through a mix of equity and liabilities.
If a company takes on debt to finance its operations or expansions, the balance sheet can also be used to assess if the company has enough assets to cover these liabilities. This is called solvency, and refers to the company’s ability to meet its debt obligations.
Since like other statements balance sheets also contain multiple years of data for the same metrics, patterns can be understood and derived from the evolving performance of the company. This is usually done through financial ratios which contrast two or more metrics at once in a ratio to make them comparable either to other companies in the industry or to another benchmark or index.
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Frequently Asked Questions
Balance sheets are typically prepared at the end of an accounting period, which can be annually, quarterly, or even monthly for some businesses. The frequency depends on the company’s size, reporting requirements, and internal needs.
Technically, no. The balance sheet equation (Assets = Liabilities + Equity) ensures both sides will always have a positive total value. However, there can be situations where one side has a much higher value than the other. For example, a company with significant debt financing might have a much higher liabilities value than equity.
Intangible assets represent non-physical resources with economic value, such as patents, trademarks, or copyrights. They are reported on the balance sheet at their historical cost minus any accumulated amortisation (reduction in value over time).
The income statement focuses on a company’s profitability over a specific period. The net income figure at the bottom of the income statement flows directly into the retained earnings section of the shareholder’s equity on the balance sheet. This increases the total equity, reflecting the company’s profits being reinvested in the business.
Cash flow to debt ratio assesses the company’s ability to service its debt with its operating cash flow.
Return on equity (ROE) measures how effectively the company is generating profits from its shareholders’ investments.
There are several other ratios that can be used on a case-to-case basis to assess the connection between statements. Usually, they are very specific depending on what it is you’re trying to analyse.