A company’s balance sheet is an important financial statement that lists its assets, liabilities and shareholders’ equity.
Along with a company’s income statement and cash flow statement, the balance sheet is one of three fundamental financial statements issues by a company to report its overall financial status to its investors.
Below, we’ve explained what a balance sheet is and why it’s important. We’ve also covered the three sections that make up a company’s balance sheet and their significance for investors with an interest in the company.
What is a Balance Sheet?
A balance sheet is a statement that displays a company’s total assets, total liabilities and total shareholders’ equity.
Sometimes, a balance sheet is referred to as a “statement of financial position” or “statement of net worth”. A company’s balance sheet is typically split up into three sections:
The first section of a balance sheet lists the company’s assets
The second section of a balance sheet lists the company’s liabilities
The third section of a balance sheet details shareholders’ equity
Most companies issue a balance sheet to their investors every quarter. By comparing a current balance sheet to previous balance sheets issued by the same company, investors can track a company’s performance over the long term and assess its financial health.
Below, we’ve explained how the assets, liabilities and shareholders’ equity sections of a balance sheet work in more detail.
Assets are the things a company owns. Company assets are typically categorised as “current assets” or “long-term assets”.
Current assets are assets that a company can easily convert to cash in one year or less, such as inventory, marketable securities, short-term investments and accounts receivable. Any cash that a company has in its bank accounts is also considered a current asset.
Long-term assets are others assets that have commercial or exchange value. For example, if a company owns a headquarters or manufacturing plant, this is a long-term asset that has its own commercial value. Long-term assets are also referred to as “non-current” assets.
Assets are listed in the “assets” section of a company’s balance sheet in order of liquidity. The assets the are the easiest to convert into cash, such as cash or cash equivalents, are listed at the top of the order of accounts, while non-current assets are listed below.
Liabilities are any debts owed by a company to its suppliers, lenders or other creditors. Just like assets, liabilities can be current or non-current depending on when they’re due.
Current liabilities include rent, interest payable on loans, taxes, utility bills, wages payable to the company’s employees, debt payments and dividends. Non-current liabilities include all liabilities that aren’t due in one year, such as pension fund liabilities, long-term debt and deferred taxes.
Companies need to list almost all of its liabilities on their balance sheet. However, some types of liabilities, such as partnerships and operating leases, are legally considered “off-balance sheet” financing and do not always need to be reported on a company’s balance sheet.
Shareholders’ equity (SE) is the total value of the shareholders’ ownership of the company after debts have been paid. It’s often referred to as “net assets”, as it accounts for the total value of a company’s assets minus any liabilities the company might have.
Shareholders’ equity can be calculated using the following simple formula:
Shareholders’ Equity = Total Assets - Total Liabilities
By looking at the shareholders’ equity section of a balance sheet, investors can see how much money would be returned to them if the company’s assets were liquidated.
When the shareholders’ equity in a company is positive, the company has enough assets to pay for its liabilities. This means that the company is solvent. If shareholders’ equity is negative for a long period of time, the company might be considered “balance sheet insolvent”.
Most of the time, some of a company’s net earnings are reinvested into the business or used to pay off a company’s debts. These earnings is categorised as retained earnings. The rest might be paid to the company’s shareholders as dividends.
Depending on the structure of the company, the shareholders’ equity section might also provide information on common stock, preferred stock and any capital surplus.
The Limitations of a Balance Sheet
Like other financial statements issued by companies, balance sheets provide a huge amount of information to investors. However, they’re far from perfect,with numerous limitations that make it important for investors to also look at other sources of financial data.
First, the contents of a company’s balance sheet depend on the account method that’s used by the company. Under some accounting methods, the company’s management might have room to distort the figures used in a balance sheet to paint an inaccurate picture of its finances.
This makes it important to also review other financial statements, such as a company’s income statement and cash flow statement.
Second, a balance sheet only lists assets that have been acquired through transactions. Some assets, such as a highly trained, productive team, might be extremely valuable to the company but not included in the assets listed on the company’s balance sheet.
Third, many long-term assets have a value that isn’t concrete. For example, real estate assets such as land or offices can fluctuate in value, meaning they could be worth more or less in the future than the value provided on a balance sheet due to changes in market conditions.
In general, it’s important to remember that a company’s sheet represents its assets, liabilities and shareholders’ equity only at a specific point in time.
Being able to read and understand a company’s balance sheet is an important skill for every investor. By reading and comparing several balance sheets from the same company, you can monitor its performance and progress over a specific period of time.
Like all financial statements, balance sheets have several limitations. However, used alongside other statements, such as a company’s income statement and cash flow statement, the balance sheet can give you a thorough, accurate understanding of a company’s financial condition.