What Is a Balance Sheet?
A balance sheet provides a picture of a company’s assets and liabilities, as well as the amount owned by shareholders. A balance sheet can help you determine what a business is really worth. When reviewed with other accounting records and disclosures, it can warn of many potential problems and help you to make sound investment decisions.
The Role of the Balance Sheet in Financial Statements
For every business, there are three important financial statements you should examine:
- The Balance Sheet tells investors how much money a company or institution has (assets), how much it owes (liabilities), and what is left when you net the two together (net worth, book value, or shareholder equity).
- The Income Statement is a record of the company’s profitability. It tells you how much money a corporation made or lost.
- The Cash Flow Statement is a record of the actual changes in cash compared to the income statement. It shows you where the cash was brought in and where the cash was disbursed.
What Information Does a Balance Sheet Include?
A balance sheet is a financial statement that shows you three things about a company:
- Assets: How much the company owns
- Liabilities: How much the company owes
- Shareholder equity: What’s left when you subtract liabilities from assets
A balance sheet only shows you a company’s financial status at one point in time. If you want to know how a company’s assets and liabilities have changed over time, you will need to have historical balance sheets to compare.
Analyzing Assets on a Balance Sheet
Current assets have a lifespan of one year or less, meaning they can be converted easily into cash. Such asset classes include cash and cash equivalents, accounts receivable, and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks. Cash equivalents are very safe assets that can be readily converted into cash; U.S. Treasuries are one such example. Accounts receivables consist of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit; these obligations are held in the current assets account until they are paid off by the clients.
Lastly, inventory represents the company’s raw materials, work-in-progress goods and finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large number of raw materials, while a retail firm carries none. The makeup of a retailer’s inventory typically consists of goods purchased from manufacturers and wholesalers.
Non-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year, and/or have a lifespan of more than a year. They can refer to tangible assets, such as machinery, computers, buildings, and land. Non-current assets also can be intangible assets, such as goodwill, patents, or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company – the value of a brand name, for instance, should not be underestimated.
Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.
Analyzing Liabilities on a Balance Sheet
Liabilities are any money that a business owes. They cover bills for supplies, rent, utilities, company salaries, loans, or deferred taxes. Just like assets, there are two types of liabilities: current liabilities, which a company owes within the next year, and long-term liabilities, which the company must pay anytime beyond one year from now.
Current liabilities include any money that the company owes to other parties in the short term.
Accounts payable covers what a company owes to its suppliers. It also includes services the company purchased using credit. As the company pays off these liabilities, its cash (current assets) will decrease by an equal amount.
Current Debt and Notes Payable
This includes any promissory notes that a company has issued. A promissory note is simply an agreement by the company to pay a certain amount of money by a certain date. A common scenario that results in a note is when a company buys expensive equipment but does not pay the entire price immediately.
If a company has debt or accounts payable, it will also have to pay interest on that debt. The result is another line on the balance sheet for “interest payable.”
Again, this is a short-term liability so the company owes the price within one year. You may also see a section on a balance sheet for long-term debt and notes payable.
Current Portion of Long-Term Debt
Long-term debt is primarily included in the long-term liabilities section. However, any money that a company owes on that debt within the next year will be included here. For example, say that a company takes out a loan that’s 10 years long. The company doesn’t have to pay the full loan in the upcoming year, but it does have to pay a certain amount. That amount falls into this category. Not all companies will list this liability and some will lump it with the current debt that we talked about in the previous section.
If a company borrows money but doesn’t have to pay it back in the short term, it’s accounted for here.
Bonds payable include any bond that the company has issued. The value here is the amortized amount of the bond. Amortization is the process of taking an expense and expanding its cost over the life of the expense.
Other Long-Term Debt and Liabilities
Bonds may be just one part of the long-term liability picture. Any other debt and liability that doesn’t have to be paid in the next year should be included. (If the balance sheet listed the current portion of this debt in the “Current Liabilities” section, it is excluded from this section.) Other long-term liabilities will include any other loans or long-term debt the company may have taken on. It may also include an estimate of what the company will have to pay to employees with pensions, and any other types of deferred compensation.
A company will have a schedule that outlines its outstanding debt, including interest expenses, and how much the company must pay per period.
Shareholders’ equity is the initial amount of money invested in a business. If at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet and into the shareholder’s equity account. This account represents a company’s total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders’ equity on the other side.
By knowing how to analyze a company’s financial information, you can determine:
- How much debt the business has relative to its equity
- How quickly customers are paying their bills
- Whether short-term cash is declining or increasing
- The percentage of assets that are tangible (e.g., factories, plants, and machinery) and how much comes from accounting transactions
- Whether products are being returned at higher-than-average historical rates
- How many days it takes, on average, to sell the inventory the business keeps on hand
- Whether the research and development budget is producing good results
- Whether the interest coverage ratio on the bonds is declining
- The average interest rate a company is paying on its debt
- Where profits are being spent or reinvested
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