A balance sheet is an important financial statement that reports on a company, business, or organization’s profits and assets. While American businesses follow generally accepted accounting principles when developing balance sheets, foreign businesses may follow International Financial Reporting Standards (IFRS).
Balance sheets are important because they show how a company spends its money and utilizes its assets. It would be unwise of a company to spend money blindly and acquire debts without keeping track of everything. Balance sheets not only display a business’ current financial situation, but they can also help businesses avoid falling into bankruptcy or dealing with extreme profit losses when they are utilized correctly.
What Are Balance Sheets, and What Do They Say About a Company’s Financial Position?
Balance sheets are a current representation of a business’s assets, liabilities, and shareholders’ equity. A company’s assets are the result of its liabilities and shareholders’ equity. Liabilities are expenses a business is responsible for, and shareholder equity refers to how much of a company is owned by shareholders or investors. Essentially, balance sheets show a company’s debts, expenses, and profits.
Investors usually want to see a company’s balance sheet to see how well a company is doing, how much in profits they can expect, as well as the company’s capital structure. Capital structure refers to how a company uses debts and income to shape its plans for financial growth and success.
Balance sheets show a company’s assets at a particular point in time, so, if you want to get an idea of how a company is doing in a long-term sense, it is best to look at multiple balance sheets.
A balance sheet can also be used to derive a few ratios that will help assess a company’s current financial health. Those ratios, sometimes called gearing ratios, are the debt-to-equity ratio and the acid-test ratio.
A debt-to-equity ratio is used to calculate a company’s financial leverage or how well they are able to borrow money in order to invest in potential assets. The debt-to-equity ratio is calculated by taking a company’s total shareholder equity and dividing it by its current liabilities. This ratio tells shareholders or other interested parties how much a company is financing its own operations instead of acquiring debt to cover expenses.
The acid-test ratio, sometimes called the quick ratio, determines how well a company can cover short-term liabilities using short-term assets. You can determine a company’s acid-test ratio by taking the total cash, marketable securities, and accounts receivables and dividing it by the company’s current liabilities.
What Are the Components of a Successful Company’s Balance Sheet?
There is a general balance sheet equation that business owners and shareholders may use to assess a company’s financial position and success. In general, the balance sheet formula is equal assets minus liabilities and shareholders’ equity.
Balance sheets are generally comprised of three different financial components, they are assets, liabilities, and shareholders’ equity.
On a balance sheet, assets are listed in reference to their liquidity. Liquidity references how quickly and how easily a company’s assets may be converted into physical cash. Assets are also divided into two categories, current assets and non-current assets, also called long-term investments.
Current assets are assets that can be liquidated in approximately one year or less. Long-term assets are assets that will take longer than one year to liquidate.
Some examples of current assets are:
- Cash or Cash Equivalents: Cash refers to physical currency, and cash equivalents would be assets like treasury bills or short-term CDs.
- Marketable Securities: Marketable securities refer to assets that have a corresponding liquid market.
- Accounts Receivable (AR, or A/R): Accounts receivable refers to the amount of money that customers currently owe a business. Sometimes, companies include an extra allowance for this category to make up for customers potentially not paying off what they owe.
- Inventory: Inventory simply refers to goods and services that are available for immediate sale.
- Prepaid Expenses: Prepaid expenses represent how much a company has already paid for certain goods or services, including but not limited to insurance, marketing costs, and possibly rent if the company is run out of a brick-and-mortar location.
Some examples of long-term assets include:
- Fixed Assets: Fixed assets are properties that are continuously used to help generate a company’s profits. These may include land, machinery used to produce goods, as well as business locations, and other buildings.
- Intangible Assets: Intangible assets are non-physical assets, such as intellectual property, used to generate business profits. Usually, businesses will list intangible assets on a balance sheet if the asset was developed by a third party instead of within the company/business.
As mentioned, liabilities are any expenses that a business or company may owe to a third party. These expenses can include everything from bills, bonds, rent, utilities, payroll, etc. Similar to assets, liabilities are also broken down into two categories, current liabilities, and long-term liabilities. Current liabilities are expenses that need to be paid off within one year or less. Usually, balance sheets list current liabilities in order of their due date. Long-term liabilities, also called non-current liabilities, are expenses that are due beyond the scope of one year’s time.
Some examples of current liabilities are:
- Accounts payable. Accounts payable is perhaps the most important current liability listed on a balance sheet. This liability refers to the debt obligations listed on invoices that were processed and due within approximately 30 days or one month.
- The current portion of long-term debt. For example, say a company has five years to repay a loan. Expenses due within that first year will be included in current liabilities, while the rest of the expenses will be included with long-term liabilities.
- Interest payments.
- Payroll expenses, including wages, salaries, and other employee benefits. Payroll expenses for the current pay period will be listed with current liabilities, while projected payments will be included with long-term liabilities.
- Customer prepayments for goods or services that the company must provide within one year.
- Payments that have been authorized but not yet officially issued.
- Earned and unearned premiums. Premiums can be similar to prepayments, given that they are both ways for a company to receive money upfront, but they still have to either pay back the money or provide the customer with the goods or services they paid for.
Some examples of long-term liabilities are:
- Long-Term Debt: Long-term debts include expenses like certain interest payments or principles on bonds that were issued.
- Deferred Tax Liability: Deferred taxes refer to the amount of taxes due that won’t be paid for at least another year.
- Pension Funds: Pension fund contributions refers to the money a company is required to pay for employee retirement accounts.
Keep in mind that not all liabilities are listed on a balance sheet. Minor expenses that don’t have a significant business impact may be considered too insignificant to be included on an official balance sheet.
Shareholder equity refers to the money that is designated for the owners of a company or its shareholders. Shareholder equities are also referred to as net assets because they are equal to the total assets a company has minus any liabilities or existing debts they owe to people or entities that are not shareholders.
Retained earnings are usually included with shareholder equity because these net earnings are reinvested into the business or used to pay off current or long-term liabilities. Treasury stock, stocks that a company has repurchased, is also included with shareholders’ equity.
The preferred stock will also usually be listed in the shareholder equity section of a balance sheet. Preferred stock refers to stocks that are given an arbitrary value by a company at the time of purchase. These stocks usually have no major impact on the market value of the shares of a company. The formula used to calculate both common and preferred stock accounts is the number of shares issued multiplied by the arbitrary stock value assigned by the company.
Lastly, the capital surplus is also usually included in the shareholder equity section of a balance sheet. Capital surplus refers to money that shareholders have invested that exceeds the value of any preferred or common stocks.
How To Prepare a Balance Sheet
According to the Harvard Business School, there are five main steps in developing a proper balance sheet. The five basic steps to preparing a balance sheet are:
- Determine the accounting period. The accounting period is the date range a current balance sheet represents. Some businesses may decide to produce balance sheets on a monthly or quarterly basis.
- Identify assets.
- Identify liabilities.
- Calculate shareholder’s equity.
- Complete the balance sheet formula. Add the total amount of liabilities and shareholder’s equity to determine the official asset value.
What Other Financial Statements Does a Business Need?
Besides a balance sheet, there are two other core financial documents businesses can use to assess their current financial health and business standing. They are an income statement and a statement of cash flow.
An income statement is a document that reports a company’s revenues, expenses, profits, and losses. Another term for an income statement is a profit and loss statement (P&L statement) or a statement of revenues and expenses. An income statement can give shareholders or investors insight into a company’s management efficiency, performance success, and can also identify underperforming areas or initiatives.
Cash Flow Statement
A statement of cash flow, also called a cash flow statement (CFS), reports on incoming and outgoing cash and cash equivalents. A CFS can give great insight as to how well a company manages its income and various expenses.