What is the balance sheet?
The balance sheet is one of the fundamental financial statements of a business that represents a company’s assets, liabilities and shareholders’ equity at a specific point in time. (We have a great overview on our “Balance Sheet Overview” video.) The balance sheet reports the total assets of the company and whether assets are financed with debt or equity. Thus, the balance sheet is considered as the snapshot of what a company owns and owes along with the invested amount by shareholders. It is critical to being successful in corporate finance.
The Accounting Equation
The accounting equation is the proposition and basic principle of accounting. It is the fundamental element of the balance sheet that sets the foundation of double-entry accounting where every transaction affects both sides of the accounting equation.
Assets = Liabilities + Owners Equity
According to the equation, the balance sheet is divided into two sides. The left side of the balance sheet represents the total assets of the company and the right side presents the liabilities and shareholders’ equity of the company.
Balance sheet items of the company are compared with those in previous years and also without similar businesses in the same industry to find out the financial condition of the company over time and against competitors. The balance sheet of Microsoft in 2019 is given below as an example of a balance sheet structure.
Figure: Example of Balance Sheet (Microsoft)
Difference between Income Statement and Balance Sheet
The income statement and balance sheet are two fundamental financial statements among the three. The income statement, also known as the profit and loss statement, refers to the financial statement of a company representing the income and expenditure of the company over a specific period. The income statement helps the company to find out whether it is making a profit or loss for that period.
The key difference between the balance sheet and income statement is that the balance sheet outlays assets, liabilities and shareholders’ equity of a company while the income statement outlays the income and expenditures of the company. Moreover, the balance sheet represents the financial condition of the company at a specific point in time (at 31st December) while the income statement represents the financial performance of the company over a period of time (for the year 2020-2021). For example, bank statement vs. your bank balance. The bank statement shows all the inflows and outflows and whether there had been more coming in than going out. On the other hand, the bank balance shows what account have in there right now.
Key components of Balance Sheet
An asset is an economic resource owned by the company that will provide a future benefit. Assets include the resources of value that owned by the company through company transactions, prepaid expenses that have not been expired and measurable cost that have a future value. In other words, assets are the resources that in future will generate cash flow, reduce expenditure, increase sales and improve the overall value of the company. In the balance sheet, assets are recorded at their cost and not adjusted for change in market value. The balance sheet includes current assets and non-current assets.
Figure: Example of Asset section in the Balance sheet
i. Current Assets:
Current assets refer to the short-term assets that have high liquidity and can be converted into cash within the company’s fiscal year. the company depends on currents assets to run its day-to-day business operations, meet short-term obligations and pay current expenses. The formula for calculating current asset is given here.
Current Assets = Cash + Cash Equivalents + Inventory + Accounts Receivable + Marketable Securities + Prepaid Expenses + Other Liquid Assets
Cash and cash equivalent: These are the most liquid assets of a company. Cash includes cash on hand and cash on bank accounts that can be deposited on demand. The cash equivalent includes interest-bearing short-term treasury bills, short-term certificates of deposit, and debt securities with maturities of less than 90 days.
Inventory: Inventory refers to the finished goods that are available for sale or raw material used in manufacturing the finished goods available for sale. Inventory can include the items that are ready for sale, in the process of being produced for sale and consumed in the production process.
Accounts receivables: This asset refers to the money that the company owns from the customers for the goods and services delivered that are expected to be paid within a year. The accounts receivables also include the allowance for doubtful accounts which indicates a certain proportion of due money is expected to remain unpaid by customers.
Prepaid expenses: These represent the value that the company has already paid for but have not yet received, expected to receive within a year. Prepaid expenses include advance payment of insurance, rents, and advertisements.
Other current assets: other current assets include advance salaries paid to employees, advance payment to suppliers, and cash surrender value of life insurance policies.
ii. Non-current Assets:
Non-current assets are those assets that cannot be easily liquidated and takes more than one year to realize full benefits. These are the long-term investments of the company from which the company gets benefits over several fiscal years. The formula for calculating current asset is given here.
Non-current asset= Property, Plants, and Equipment + Intangible assets + Long-term Receivables
Property, Plants, and Equipment (PP&E): These are the tangible long-term assets of the company. These include land, machinery, equipment, buildings and other durable, generally capital-intensive assets.
Intangible assets: Intangible assets include patent, copyright, franchises, goodwill, trademarks, and trade names. These assets do not have any physical presence. However, these assets can generate cash flow or benefits to the company. For example, because of goodwill, when a company buys another company, it may pay more for it than the sum of the fair value of the company
Long-term Receivables: These assets are the long-term investments of the company that will not be liquidated with a fiscal year. Long-term Receivables includes long-term savings certificates, investments in stocks, bonds and securities.
Liabilities are legally binding financial obligations that are payable to another person or entity resulting in the company’s future sacrifices of economic benefits to other entities. Liabilities are a source of a company’s financing that can be used to support the asset base of the business. The balance sheet includes current liabilities and non-current liabilities.
Figure: Example of items under Liabilities in Balance Sheet
i. Current Liabilities
Current liabilities are short-term financial obligations of the company that are to be paid within a year. It is the amount that is generally concerned for a particular business cycle. To fulfil this liability, the company has to maintain liquidity in assets.
Current Liabilities= Accounts payable + Accrued expenses + Unearned revenue + Current portion of long-term debt + Short-term Notes payable+ other short-term debt.
Accounts payable: Accounts payable represents the short-term debt obligations to the suppliers or vendors of the company for invoices that have yet to be paid within one year.
Accrued expenses: These are the liabilities origins from the expenses that are recorded in accounting following the accrual method of accounting but have yet to be paid. Thus, all expenses that are recognized when they’re incurred, before paid, are accrued expenses.
Unearned revenue: These are the liabilities that arise when the company receives money from the sales of goods and services that are yet to be delivered to the customer. In this case, the company has received the money but yet to be earned by delivering the promised goods or services.
Current portion of long-term debt: this liability represents a section of the company’s long-term debt or the amount of unpaid principal from long-term debt that has accrued in a company’s normal operating cycle and has to be repaid within the fiscal year.
Other current liabilities: Other current liabilities include accrued discounts and liabilities (rebates or discounts owed back to the customer for purchases they have made), progress collections (cash paid in advance of a delivery period), salaries and wages payable, bank account overdrafts, income taxes payable, and interest payable.
ii. Non-current Liabilities
Non-current liabilities refer to the financial obligations of the company that can be paid within more than one year. Non-current liabilities are acquired to undertake capital expenditure of the company.
Non-Current Liabilities = Long term lease obligations + Long Term borrowings + Secured / Unsecured Loans + Provisions +Deferred Tax Liabilities + Derivative Liabilities + Other long-term liabilities.
Long-term debt: Long Term Debt (LTD) represents the amount of outstanding debt that a company holds with a maturity longer than one year. These long-term obligations origins from the acceptance of the funds from third parties for the need for meeting capital expenditure and making strategic decisions. Long-term debt includes bank loans, mortgages, bonds and debentures.
Other long-term liabilities: these liabilities include employee benefits and pensions, deferred income taxes, long-term deferred income, deferred credits, capital leases and customer deposits.
3. Owners’ Equity:
The owner’s equity represents the proportion of the total value of the assets of the company that can be claimed by the owner or shareholders. It is the residual claim on the company’s assets after meeting all obligations of the debtholders.
Equity = Assets – Liabilities
Retained Earnings: Retained earnings represents the accumulated portion of a business’s profits that are not distributed to the shareholders. Retained earnings are not used for dividend rather used for reinvesting into the company as working capital and capital expenditure or debt repayment.
Common stock: Common stocks represent the ownership of equity in the company with the right to vote and elect the board of members of the company. The common stock section under owner’s equity includes both common shares and preferred shares.
Benefits of Balance Sheet
Financial position: A balance sheet provides the business snapshots representing the assets, liabilities and ownership of the company. It helps management to understand the current financial position of the business and make financing and strategic decisions accordingly.
Capital structure: A balance sheet shows the capital structure of the business representing the amount of debt and equity of the company. Thus, the users of the balance sheet can determine the risks and returns of the company.
Ratio analysis: by using the information of the balance sheet, the user can calculate importee ratios such as Return of Equity, Return on Asset, Current ratio, Inventory Turnover etc.
Limitations of Balance Sheet
Historical Price: The items under a balance sheet are recorded in historical price. The balance sheet does not consider the changes in market prices. Thus, balance sheet results are not market-driven and can be misleading.
Variance in Rules: In balance sheets, different assets can be valued following different rules. Again, there can be a difference in rule among different companies which make it difficult to compare to each other.
Snapshot for a specific date: The balance sheet only shows the financial position of the company at a specific point in time. Thus, it cannot show the actual condition of the financial items over a period of time.