What Is a Balance Sheet?
A balance sheet (also called a statement of financial position) is a statement that provides a snapshot of a company’s financial situation at a given date. It reports assets, liabilities, and shareholder’s equity to provide an overview of what a company owns, what it owes, and what is left over for the owners.
Along with the income statement and cash flow statement, balance sheets are an essential financial statement that monitors a business’ health. It can also be used alongside the other two financial statements to calculate financial ratios or conduct fundamental analysis.
How to Read a Balance Sheet
Balance sheets are divided into two sections: the left side lists a company's assets whereas the right side lists the company’s liabilities and shareholders' equity. In order for the statement to balance, the company’s assets must equal its financial obligations and equity.
Items are listed in decreasing order of liquidity and categorized as current (ie. short-term, less than 1 year) or non-current (ie. long-term, more than 1 year). Depending on the business and industry, the exact items on each balance sheet will vary, but they all fall into one of three categories:
Assets are any tangible or intangible resources that can be used to produce positive economic value. On balance sheets, they are categorized as current assets (short-term) or long-term assets, and listed in order of liquidity (how easily they can be converted into cash).
Examples of current assets can include:
Inventory and Supplies
Liabilities are debts or obligations – like money owed or services to be rendered – arising from past business transactions or events. They sacrifice future economic benefits in exchange for present-day goods or services. They are broken down into two categories:
Taxes payable (e.g sales, payroll, income)
Current portion of long-term debt
Short term loans
Rent and utilities
Accrued expenses (e.g. wages payable)
Dividends and interest payable
Pension fund payable
Equity is the total amount of capital invested in a business, plus any retained earnings. It represents the value of ownership (after subtracting all debts) and is calculated by subtracting total liabilities from total assets. On a balance sheet, this section generally includes:
Balance Sheet Equation
The term “balance sheet” comes from the expectation that the left (assets) and right (liabilities + shareholders’ equity) columns of the statement will balance.
Companies borrow money (increasing liabilities) or issue stock (increasing shareholders’ equity) to pay for assets, so the two sides should always balance to zero. The balance sheet equation is used to achieve this:
Assets = Liabilities + Shareholders’ equity
Types of Balance Sheets
There are multiple types/formats of balance sheets, each providing different information about a business. These, however, are the most common:
Classified Balance Sheet
Classified balance sheets are the most common type of balance sheet. They classify all items into subcategories of accounts such as:
Vertical Balance Sheet
Rather than listing assets in the left column and liabilities/shareholders' equity in the right, a vertical balance sheet lists all line items in a single column. This format allows accountants to include additional columns to compare balances across multiple periods – or view relative percentages of individual line items.
Common Size Balance Sheet
A common size balance sheet is similar to a vertical balance sheet but with an additional column that lists the relative percentages of assets, liabilities, and shareholders’ equity. Each individual line item is listed as a percentage of the total of its corresponding section. This allows a reader to compare each line’s contribution to the total figure.
Comparative Balance Sheet
A comparative balance sheet is a financial statement that provides information on assets, liabilities, and equity over multiple points in time. It also lists balances from previous periods alongside recent balances, allowing the reader to make comparisons, track progress over time, and identify trends.
Why Are Balance Sheets Important?
Balance sheets are essential in measuring financial health as they keep track of all of a business’ transactions. This data can be beneficial in many ways:
Calculating Financial Ratios
Balance sheets provide information needed to calculate various financial ratios like debt-to-equity ratio, current ratio, and quick ratio.
With enough data, you can identify trends in assets and liabilities (and even forecast future balance sheets).
Using information from multiple time periods, you can track financial health over time and compare that data with other companies.
Conducting Fundamental Analysis
Used in combination with other financial statements, balance sheets can help analysts determine whether a company is under or overvalued.
Influencing Future Financial Decisions
Balance sheets can help companies determine how to increase efficiency, finance operations, meet financial obligations, and much more.
Attracting Investors or Acquirers
Balance sheets provide information on assets, turnover, liquidity, and other important variables that are valuable to potential investors or acquirers.
Securing Loans and Other Capital
Lenders can compare the amount of debt to equity to determine whether a company has the ability to repay potential loans.
Limitations of Balance Sheets
While balance sheets are an excellent measure of a company’s financial health, there are some limitations:
Variance in Valuation
Many assets are valued according to different rules. Some are valued on an estimated basis, making it difficult to reflect a company’s true financial position.
Uses Monetary Terms Only
Balance sheet items are only measured in monetary terms, making it difficult to quantify intangible assets like goodwill -- the value of branding, customer loyalty, internally-developed projects, etc. Accounting rules actually require companies to test goodwill as an asset annually.
Disregards Changes in Value
Assets are recorded at the original price when they were acquired by the company, ignoring any changes in value over time.
Room for Manipulation
Balance sheets provide a snapshot at a specific date. Therefore, companies can repay loans, delay purchases, and perform other activities to influence the end result.
Balance sheets provide an overview of a company’s financial health at any given date. In order to identify trends, track progress, and unlock other benefits, companies must include data from previous years (or supplement balance sheets with other financial statements).
Balance Sheet vs Income Statement
Balance sheets and income statements are two of the most important financial statements but they each offer different perspectives on a company’s financial situation:
A balance sheet reports a company’s assets, liabilities, and shareholders’ equity at a given point in time, illustrating how the company uses its debt and assets to generate revenue.
An income statement (often called a profit and loss statement) lists a company’s revenues and expenses over a period of time. It helps the reader understand how the company converts revenue into profit which indicates profitability.
Balance Sheet vs Cash Flow Statement
Balance sheets and cash flow statements are essential financial statements that are useful together but valuable in their own right.
A balance sheet provides a snapshot of a company's financial health at a given point in time, allowing the reader to understand how it uses debt and assets to generate revenue.
A cash flow statement lists a company’s inflows and outflows of cash over a period of time, highlighting how it generates and manages cash. It informs the reader about how much cash is available for bills, payroll, debt obligations, and other operating expenses.
Balance Sheet Example
Tom is an accountant for Catering Company ABC and is trying to prepare a balance sheet at the end of the year. After gathering the company’s paperwork, he discovers the following assets, liabilities, and shareholders’ equity:
$5,000 in a checking account
$2,000 in unpaid invoices (accounts receivable)
$1,000 of oils, spices and other inventory
$14,000 in cooking and serving equipment
$10,000 land the kitchen is built on
$7,000 in invoices due (accounts payable)
$3,000 in wages payable
$42,000 in common stock
$20,000 in retained earnings
Catering Company ABC
December 31st, 2019
|Assets||Liabilities & shareholders' equity|
|Current assets||Current liabilities|
|Accounts receivable||$2,000||Wages payable||$3,000|
|Inventory||$1,000||Total current liabilities||$10,000|
|Total current assets||$8,000||Total liabilities||$10,000|
|Total long-term assets||$64,000||Total shareholders' equity||$62,000|
|Total assets||$72,000||Total liabilities & shareholders' equity||$72,000|