DEFINITION: A balance sheet is a financial statement that provides essential information regarding a company’s assets, liabilities, and shareholder equity.
When combined with other kinds of financial statements, a balance sheet may provide the foundation for an informed analysis of a company’s financial condition.
ETYMOLOGY: The first use of the English phrase “balance sheet” dates from 1838.
The word “balance” comes from Middle English via Old French and, ultimately, the Vulgar Latin bilancia, which was constructed from the classical Latin prefix “bi-” (two) and noun, lanx, lancis (plate, flat dish).
The word “sheet” derives from the Middle English shete and Old English sceāta, which means the lower corner of a sail. Sceāta, in turn, is related to Old English scȳte, meaning sheet.
USAGE: A balance sheet provides an overview of the state of a company’s finances at a moment in time, like a snapshot.
Because a single balance sheet cannot give a sense of temporal trends affecting a company’s financial well-being, it is important to compare a company’s present balance sheet with ones from earlier months and years.
Various ratios obtainable from a company’s balance sheet, such as the debt-to-equity ratio and the acid-test ratio, among others, make it possible for investors to gauge a company’s financial health.
A balance sheet is structured around three fundamental accounting quantities, which may be related to one another by means of the following equation:
Assets = Liabilities + Shareholder Equity
This equation holds true because all of a company’s assets, that is, its possessions, must be paid for either through borrowing (i.e., liabilities, or debt) or through received (i.e., investments, or shareholder equity).
The balance between the two sides of the equation indicates the state of a company’s financial health.
For example, if a company obtains a loan from a bank for, say, $10,000, this increases both its assets and its liabilities by that same amount. Thus, the left-hand side of the equation remains equal to the right-hand side.
The same thing is true if a new investor injects, say, $5000 into the company. Both the company’s assets and shareholder equity will increase by that same amount.
Profits from operations and investments are assigned to both the company’s assets and shareholder equity, thus maintaining the balance.
In short, a company’s balance sheet, as its name implies, should always show a balance between assets on one side and the sum of liabilities plus shareholder equity on the other.
If this is not the case, something is wrong somewhere. One must look for the source of the error, which may be due to the assignment of data to the wrong category, inaccuracies in the calculation of inventory, or mistakes relating to exchange rates or straightforward computational errors.
Each of the balance sheet categories is composed of subaccounts that detail a company’s financial specifics.
Such subaccounts may differ greatly depending on the industry, such that the same terms may convey different meanings.
However, there are several common elements to each of the major component categories of a balance sheet that all investors should be familiar with.
Let us look at each of these in turn.
Balance Sheet Components
The subaccounts under this category have been listed in descending order of liquidity (meaning the ease with which an asset can be converted into cash).
The subaccounts may be classified into two groups: current assets, which can be turned into cash within a year or less, and non-current or long-term assets, which may take longer than a year to convert to cash.
Current assets are made up of the following subaccounts:
- Cash and cash equivalents, being the most liquid asset, include Treasury bills and short-term certificates of deposit (CDs), as well as cash itself (currency).
- Marketable securities comprise equity and debt securities for which a ready market is likely to be available.
- Accounts receivable (AR) means the money owed to a company its customers. This category is less readily convertible into cash, since it depends on the cooperation of the customers; indeed, some accounts receivable may need to be written off altogether.
- Inventory includes any goods that are on hand and ready for sale; such goods ought to be valued at the price originally paid for them or the current market price, whichever is lower.
- Prepaid expenses are purchases that have already been paid in full, but not yet received in full, notably contracts for such services as rent, insurance, advertising, and so forth.
Non-current or long-term assets are constituted by the following subaccounts:
- Long-term investments comprise securities that cannot be converted into cash within the upcoming year.
- Fixed assets are made up of land, buildings, heavy equipment and machinery, and other immovable, high-priced assets.
- Intangible assets are non-physical assets, such as intellectual property, brands, and goodwill.
The term “liabilities” refers to financial obligations that a company owes to other companies or individuals.
The term may refer to a wide variety of kinds of payment obligations, including interest on bonds owed to creditors, bills presented by all sorts of suppliers, employees’ salaries, rent, bills for the consumption of electricity, gas, water, waste removal, and other utilities, and so forth.
Liabilities fall into two main categories: current liabilities, which are expected to be settled within one year, according to a printed due date, and long-term liabilities, which become due after one year from the reporting date.
Current liabilities encompass various accounts, which may include:
- The current portion of long-term debt: This represents the portion of a long-term debt that falls due within the next 12 months.
- Interest payable refers to the accumulated interest that a company owes; this type of liability is typically associated with surcharges on late remittances and other past-due obligations.
- Wages payable involve employees’ total compensation, including wages, salaries, and health and other kinds of benefits.
- Customer prepayments represent money received from customers before the service or product has been delivered.
- Dividends payable are shareholder dividends that have been authorized but not yet remitted.
- Earned and unearned premiums are analogous to customer prepayments—monies that a company has received per a contract, but for which the corresponding goods or services have not yet been provided.
- Accounts payable are debt obligations arising from invoices generated by normal business operations. Accounts payable—which are among the most common form of liability—are commonly due within 30 to 90 days of receipt of the invoice.
Long-term liabilities encompass various elements, such as:
- Long-term debt, which comprises interest and principal payments on bonds issued.
- Pension fund liability represents the total amount of the funds a company is legally required to contribute to its employees’ retirement accounts.
- Deferred tax liability reflects taxes accrued but not due to be paid until the next year. Additionally, this figure ought to take into account such matters as depreciation, as well as any other discrepancies that may occur between a company’s tax liability as stated in its financial reports and as currently assessed by the relevant taxing authorities.
III. Shareholder Equity
Shareholder equity, also referred to as net assets, represents the funds that belong to the owners or shareholders of a business. This amount is calculated by deducting the company’s liabilities (debts owed to non-shareholders) from its total assets.
Retained earnings refers to the net earnings from operations (profit) that a company either reinvests in its operations or else uses to repay external debt. Any net earnings remaining after the subtraction of retained earnings may be distributed to shareholders as dividends.
Treasury stock refers to shares a company has bought back from its shareholders. Treasury stock may be sold later to generate income when needed, or else held in reserve as a defensive measure against a hostile takeover.
Some companies may issue both common stock and preferred stock, which will then be listed separately in financial reporting.
Both types of stock are assigned an arbitrary par value (nominal or face value), which is the value of one share. However, this par value will not affect the market value of the shares.
Paid-in capital means the total amount of cash or other assets that a shareholder pays a company to purchase shares of its stock.
Additional paid-in capital (APIC), or capital surplus, refers to the amount of paid-in capital left over after the par value of the shares received has been deducted.
Again, these are accounting concepts that are not directly linked to any market price. Moreover, it should be noted that shareholder equity is also not directly linked to a company’s market capitalization.
Market capitalization is determined by the current stock price, whereas paid-in capital includes the total equity purchased by shareholders at various prices.
Importance of Balance Sheets
Whatever a company’s size or field of operation, reading, analyzing, and understanding its balance sheet can be a valuable guide to its financial status.
First, the balance sheet plays a significant role in assessing risk. By detailing a company’s assets, liabilities, and shareholder equity, the balance sheet reveals whether the company has taken on too much debt, whether it has sufficient cash reserves to meet its current obligations, whether its assets are sufficiently liquid, and so forth.
Second, balance sheets are crucial to obtaining capital. Whether applying for a business loan from a bank or seeking equity financing from private investors, companies will be asked to provide their balance sheets for the prospective lender’s inspection.
Finally, balance sheets can serve as a tool for attracting and retaining talent. Most employees value job security and prefer to work for companies that are financially stable.
Note that publicly traded companies are required by law to disclose their balance sheets. This transparency is especially helpful to prospective employees of a company, as it allows them to inspect its cash reserves, assess its debt management decisions, and accurately evaluate the harmony (or dissonance) between their own expectations and their future employer’s state of financial health.