The Balance sheet is one of the three fundamental financial statements and is key to both financial modelling and accounting. The balance sheet displays the company’s total assets, and how these assets are financed, through either debt or equity. It can also be referred to as a statement of net worth, or a statement of financial position.
The balance sheet is based on the fundamental equation: Assets = Liabilities + Equity.
As such, the balance sheet is divided into two sides (or sections).
The left side of the balance sheet outlines all of a company’s assets. An asset is a resource owned or controlled by an individual, business, or government with the expectation that it will generate a positive economic value. Common types of assets include current, non-current, physical, intangible, operating, and non-operating. Correctly identifying and classifying the types of assets is critical to the survival of a company, specifically its solvency and associated risks.
On the right side, the balance sheet outlines the company’s liabilities and shareholders’ equity. Liabilities are legal obligations or debt owed to another person or company. In other words, liabilities are future sacrifices of economic benefits that an entity is required to make to other entities as a result of past events or past transactions. Stockholders Equity (also known as Shareholders Equity) is an account on a company’s balance sheet that consists of share capital plus retained earnings. It also represents the residual value of assets minus liabilities.
By rearranging the original accounting equation, Assets = Liabilities + Stockholders Equity, it can also be expressed as Stockholders Equity = Assets – Liabilities.
The assets and liabilities are separated into two categories: current asset/liabilities and non-current (long-term) assets/liabilities. More liquid accounts, such as Inventory, Cash, and Trades Payables, are placed in the current section before illiquid accounts (or non-current) such as Plant, Property, and Equipment (PP&E) and Long-Term Debt.
Balance sheets, like all financial statements, will have minor differences between companies and industries. However, there are several line items that are almost always included in common balance sheets. Some commonly found line items include Current Assets, Long-Term Assets, Current Liabilities, Long-term Liabilities, and Equity.
Why is Balance Sheet used?
A balance sheet is a statement used to analyse a company’s financial position. An analyst can generally use the balance sheet to calculate a lot of financial ratios that help determine how well a company is performing, how liquid or solvent a company is, and how efficient it is.
Changes in balance sheet accounts are also used to calculate cash flow in the cash flow statement. For example, a positive change in plant, property, and equipment is equal to capital expenditure minus depreciation expense. If depreciation expense is known, capital expenditure can be calculated and included as a cash outflow under cash flow from investing in the cash flow statement.
Importance of the Balance Sheet
The balance sheet is a very important financial statement for many reasons. It can be looked at on its own, and in conjunction with other statements like the income statement and cash flow statement to get a full picture of a company’s health.
Four important financial performance metrics include:
- Liquidity – Comparing a company’s current assets to its current liabilities provides a picture of liquidity. Current assets should be greater than current liabilities so the company can cover its short-term obligations. The Current Ratio and Quick Ratio are examples of liquidity financial metrics.
- Leverage – Looking at how a company is financed indicates how much leverage it has, which in turn indicates how much financial risk the company is taking. Comparing debt to equity and debt to total capital are common ways of assessing leverage on the balance sheet.
- Efficiency – By using the income statement in connection with the balance sheet it’s possible to assess how efficiently a company uses its assets. For example, dividing revenue by the average total assets produces the Asset Turnover Ratio to indicate how efficiently the company turns assets into revenue. Additionally, the working capital cycle shows how well a company manages its cash in the short term.
- Rates of Return – The balance sheet can be used to evaluate how well a company generates returns. For example, dividing net income by shareholders’ equity produces Return on Equity (ROE), and dividing net income by total assets produces Return on Assets (ROA), and dividing net income by debt plus equity results in Return on Invested Capital (ROIC).
At Prosper Bailey Accountants, we help small businesses with balance sheets and cash flow management. Happy to help if you need professional advice.