Definition and Elements of a Balance Sheet

A balance sheet, also known as a "statement of financial position," details a company's assets, liabilities, and shareholder equity (net worth). The balance sheet, along with the income statement and cash flow statement, forms the basis of any company's financial statements.

 

The balance sheet is one of the most important financial statements for understanding a company.

 

• Potential investors must make a decision about whether or not to invest in a company, and the balance sheet provides critical information about the company's health.

 

• Business owners should develop a more effective organizational strategy.

 

• Employees must modify their processes in order to better achieve shared organizational goals.

 

• Knowing how to read and comprehend the information on a balance sheet is a critical financial accounting skill to have, whether you're a business owner, employee, or investor.

 

The balance sheet shows a company's resources (assets) as well as its capital sources (equity and liabilities/debt). This information helps an analyst determine a company's ability to meet its short-term operating needs, meet future debt obligations, and make dividend payments to shareholders. The basic equation for a balance sheet is assets = liabilities + equity.

 

What is a Balance Sheet?

 

A balance sheet is one of the three basic financial statements that are required for financial modeling and accounting. The balance sheet shows the company's total assets as well as how those assets are financed, whether through debt or equity. 

 

It is also known as a net worth statement or a financial position statement. The balance sheet is built around the basic equation: assets = liabilities + equity.

 

As a result, the balance sheet has two sides (or sections). The balance sheet's left side lists all of a company's assets. The balance sheet on the right side details the company's liabilities and shareholders' equity.

 

There are two types of assets and liabilities: current assets and liabilities and non-current (long-term) assets and liabilities. Inventory, cash, and trade payables are placed in the current section before illiquid (or non-current) accounts such as plant, property, and equipment (PP&E) and long-term debt. property 

 

Also Read |  Gilt Funds
 

 

Importance of Balance Sheet
 

A Balance Sheet is significant because it helps in understanding a company's performance. The following are some of the reasons why it is critical:

 

1. To comprehend a company's financial health,

 

2. Stakeholders can examine the balance sheet to gain a better understanding of the company's liquidity position and business performance.

 

3. Comparing balance sheets over time aids in determining the company's growth.

 

4. It is a required document when applying for a business loan.

 

5. The analysis of the company's balance sheet aids in understanding the firm's ability to undertake expansion projects and unforeseen expenses.

 

6. It aids in determining the source of a company's funding, such as equity or debt funding.

 

 

Purpose of Balance Sheet
 

 

The balance sheet reveals your company's overall financial health because it reflects every transaction since its inception. This information can be used by investors, business owners, and accountants to determine the book value of a company, but it can also be used for much more.

 

At a glance, you'll be able to see how much money you've invested or how much debt you've accumulated. Alternatively, you could compare current assets to current liabilities to ensure that you can meet upcoming payments.

 

The information on your company's balance sheet can assist you in calculating key financial ratios such as the debt-to-equity ratio, a metric that shows a company's ability to pay its debts with equity (should the need arise). 

 

The current ratio is even more immediately applicable: current assets / current liabilities. This will tell you whether you will be able to pay off all of your debts within the next 12 months.

 

You can also compare your most recent balance sheet to previous ones to see how your financial situation has changed over time. You'll be able to see how far you've come since the beginning.

 

Also Read | Ratio Analysis

 

 

Assets in Balance Sheet

 

An asset is a resource that has some economic value to a business and can be used to generate revenue now or in the future.

 

These assets, which can range from cash to buildings, are recorded on the balance sheet until they are used. When these resources are used or spent, they are transferred from the balance sheet to the income statement and are known as expenditures.

 

 

Current Assets

 

Current assets have a one-year or less lifespan, which means they can be easily converted into cash. Such asset classes include cash and cash equivalents, accounts receivable, and inventory. Cash is the most basic type of current asset, and it also includes unrestricted bank accounts and checks.

 

Cash and its equivalents - The most liquid asset, cash, appears on the balance sheet's first line. Cash Equivalents are also included in this line item and include assets with short-term maturities of less than three months or assets that the company can liquidate quickly, such as marketable securities. In general, companies will disclose what equivalents they include in the balance sheet footnotes.

 

Accounts Receivable - An account receivable is a customer's IOU. Many businesses allow customers to buy goods on credit and pay for them later. Accounts receivable is an acknowledgment from the customer that the company owes money for the goods.

 

Inventory - It consists of raw materials, work-in-process goods, and finished goods. This account is used by the company when it reports sales of goods, usually under the cost of goods sold in the income statement.

 

Examples of the current assets are:

 

• Checking account funds

 

• Money on the move (money being transferred from another account)

 

• Receivables (accounts receivable) (money owed to you by customers)

 

• Long-term investments

 

• Inventory

 

• Expenses prepaid

 

• Cash substitutes (currency, stocks, and bonds)

 

Non-current Assets

 

Non-current assets are assets that cannot be easily converted into cash, are not expected to be converted into cash within a year, and/or have a longer lifespan than a year.

 

Property, Plant, and Equipment (PP&E)- Property, Plant, and Equipment (also known as PP&E) are the tangible fixed assets of a business. Net of accumulated depreciation, the line item is noted. Some businesses will categorize their PP&E by asset types, such as land, buildings, and various types of equipment. Except for land, all PP&E is depreciable.

 

Intangible Assets- Patents, trademarks, and copyrights - All of these are examples of intellectual property that a company can own or control in order to generate revenue over time. In fact, some of the world's most valuable assets are intangible in nature. Consider the designs of Walt Disney's Mickey Mouse or Apple's iPhone.

 

Long-term assets, also known as non-current assets, include:

 

• Buildings and land

 

• Equipment and machinery (less accumulated depreciation)

 

• Patents, trademarks, copyrights, and goodwill are examples of intangible assets (you would list the market value of what a buyer might purchase these for).

 

• Long-term financial investments

 

Also Read | Revenue Deficit

 

 

Liabilities in Balance Sheet

 

A liability is a financial obligation of a company that results in the company sacrificing future economic benefits to other entities or businesses. A liability can be used as an alternative to equity as a source of financing for a business. 

 

In addition, certain liabilities, such as accounts payable or income taxes payable, are required components of day-to-day business operations. Liabilities can help businesses organize successful operations and accelerate value creation. 

 

Poor liability management, on the other hand, can have serious consequences, such as a drop in financial performance or, worse, bankruptcy. Furthermore, liabilities influence the company's liquidity and capital structure.

 

Current liabilities

 

Accounts Payable (also known as AP) - It is the amount owed to suppliers for goods or services purchased on credit. As the company pays off its accounts payable, the cash account is reduced by the same amount.

 

Current Debt/Notes Payable - Non-AP obligations that are due within a year or within the company's operating cycle are included in this category (whichever is longest). Notes payable may also be issued in a long-term version, which includes notes with maturities of more than a year.

 

Long-Term Debt- This account contains the total amount of long-term debt (excluding the current portion, if that account is present under current liabilities). This account is derived from the debt schedule, which lists all of the company's outstanding debt as well as the interest and principal repayment for each period.

 

Also Read | What is a Debenture?

 

Non-current liabilities

 

Bonds Payable - The amortized amount of any bonds issued by the company is included in this account.

 

Long-Term Debt- This account contains the total amount of long-term debt (excluding the current portion, if that account is present under current liabilities). This account is derived from the debt schedule, which lists all of the company's outstanding debt as well as the interest and principal repayment for each period.

 

Shareholder’s Equity

 

Shareholders' equity refers to the initial amount of money invested in a business. If a company decides to reinvest its net earnings (after taxes) at the end of the fiscal year, these retained earnings will be transferred from the income statement to the balance sheet and into the shareholder's equity account. 

 

This account represents a company's total net worth. Total assets on one side of the balance sheet must equal total liabilities plus shareholders' equity on the other. 
 

---

Example of balance sheet source - AccountingCoach

---

Also Read | Financial Budget

 

Balance Sheet Equation

 

The equation for the balance sheet. This accounting equation is the balance sheet's key:

 

Liabilities + Owner's Equity = Assets

 

On one hand, there are assets, and on the other, there are liabilities plus equity. The two sides must balance, which is why the term "balance sheet" was coined.

 

It makes sense: you pay for your company's assets by borrowing money (increasing your liabilities) or borrowing money from the owners (equity).

 

 

Key Points Defining a Balance Sheet

 

We’ve listed some key points that define the balance sheet below. 

 

1. The balance sheet (also known as the statement of financial position) shows what an entity owns (assets) and owes (liabilities) at any given time.

 

2. After deducting liabilities, equity is the owners' residual interest in a company's assets.

 

3. An analyst can assess a company's liquidity, solvency, and overall financial position by understanding its balance sheet.

 

4. The balance sheet distinguishes between current and noncurrent assets and current and non-current liabilities unless a presentation based on liquidity provides more relevant and reliable information.

 

5. The ability of a company to meet its short-term operating needs is referred to as liquidity.

 

6. Notes to financial statements contain information that can be used to determine the comparability of measurement bases across companies.

 

7. If a company's inventory's net realizable value falls below its carrying amount, the inventory must be written down and an expense recorded.

 

8. Property, plant, and equipment (PPE) are tangible assets that are used in business operations and are expected to be used over a number of fiscal years.

 

9. Under IFRS, property used to earn rental income or capital appreciation is classified as an investment property.

 

10. A company determines whether an intangible asset's useful life is finite or indefinite.

 

11. The impairment principles for an intangible asset with a finite useful life are the same as for PPE.

 

12. Intangible assets that have an indefinite useful life are not amortized.

 

13. The most common intangible asset that is not a separately identifiable asset is goodwill, which arises in business combinations.

 

14. Financial instruments that create both a financial asset and a financial liability or equity instrument for one entity are referred to as financial instruments.

 

15. Financial instruments are generally measured using one of two methods: fair value or amortized cost.

 

16. The statement of changes in equity contains information about how each component of a company's equity has changed over time.

 

17. Vertical common-size balance-sheet analysis requires each balance-sheet item to be expressed as a percentage of total assets.

 

18. Loans (i.e., bank borrowings) and payable notes or bonds are examples of common long-term financial liabilities (i.e., fixed-income securities issued to investors).

 

19. Liabilities, such as bonds issued by a company, are typically reported on the balance sheet at an amortized cost.

 

20. Contributed capital, preferred shares, treasury shares, retained earnings, and accumulated others are six potential components of the owners' equity section of the balance sheet.

 

21. Balance sheet ratios include liquidity ratios (which measure a company's ability to meet short-term obligations) and solvency ratios (which measure a company's ability to meet long-term and other obligations).

 

Also Read | What are Shares?

 

A balance sheet can provide insight or justification for investing in a stock. A balance sheet's purpose is to provide interested parties with an idea of the company's financial position, as well as to show what the company owns and owes. All investors must understand how to use, analyze, and read a balance sheet.