What Is a Balance Sheet?

A balance sheet is a financial document that represents a snapshot of a company’s assets, liabilities, and equity, which is useful for determining its financial position at a specific moment. It summarizes what the business owns (assets), owes (liabilities), and the other value of owners (shareholders’ equity).

The balance sheet is another important financial statement in the business world, along with the cash flow statement and income statement.

Balance sheet data is highly useful for investors to identify the rate of return on investments and for analyzing the company’s capital structure.

A typical balance sheet structure has three sections, each representing one of three components: assets, liabilities, and shareholders’ equity. The one section, as an asset, should be equal to combined liabilities and shareholders’ equity, presenting the balance between the two parts (assets and liabilities + shareholders’ equity). This is the reason it is called a balance sheet.

Key Components of the Balance Sheet

After uncovering the definition of the balance sheet, we will examine its key components, which are essential to its structure. Essential parts of the balance sheet are as follows:

Assets

Assets refer to those things that your business owns. These are the values that you can easily convert to cash, consume, or sell. The company’s bank account, building, property, trademark, and copyrights are assets. Further, it is broken down into two segments as listed below:

Current Assets

Current assets reflect those assets that are within the expectation of being converted into cash or used up within one year. These include cash (liquid assets), inventory, and accounts receivable. They represent the amount of liquidity a business holds in the short term. Market securities, inventory, cash, and accounts receivable are some examples of current assets.

Long Term Assets

The other name for long-term assets is non-current assets. Unlike current assets, these assets are not easy to convert into cash. Long-term assets are meant to help the business in the long term and not for immediate sale.

Property, Plant, and Equipment (PP&E) like buildings, land, and vehicles, intangible assets like copyrights, goodwill, and trademarks, and long-term investments like stock and bonds are examples of long-term assets.

Liabilities

Liabilities refer to financial obligations and debts. These cover the amount that the company owes to lenders, suppliers, and employees. These liabilities are also divided into two categories:

Current Liabilities

Current liabilities can cover the current portion of the long-term debt that is due within the next 12 months, as well as the salaries paid to the employees.

Current liabilities also include accounts payables (AP), which refers to the amount that the company owes suppliers for the services or products purchased on credit.

Furthermore, these liabilities also cover non-AP obligations that are pending within one year.

Long Term Liabilities

Long-term liabilities, also known as non-current liabilities, are obligations or debts due after one year. They are useful for financing heavy investments like the purchase of buildings, equipment, or projects.

These liabilities also cover bonds payable that include the interest and principal on the issued bonds.

Additionally, it covers pension funds that companies need to pay to employees in reference to their retirement plans.

Long-term liabilities also cover deferred tax liabilities, which refer to amounts that grow over a period but are not paid for another year.

Shareholders’ Equity

Shareholders’ equity represents the value of the owner’s share in the business after deducting liabilities from assets. It represents the value that belongs to the shareholders after paying off debts.

Balance Sheet Equation

So far, we have discussed what a balance sheet is and its components. We now understand the balance sheet equation. A common structure of the equation covers assets on one side while liabilities and equity financial ratios are on the other side. According to this, the balance sheet formula is:

Asset = Liabilities + Shareholders’ Equity

The above equation is useful for working on a balance sheet.

Balance Sheet Example

Here is an example of a balance sheet that you can create using financial reporting software like Moon Invoice. The software is quite handy and helps generate accurate reports quickly.

The above example shows a company’s balance sheet, which includes assets, liabilities, and shareholders’ equity.

The section on the left-hand side shows assets that are classified as current assets and other assets. It also shows less accumulated depreciation of $5,000 and less accumulated amortization of $200.

So, calculating the total current assets and other assets while subtracting the depreciation and amortization will yield $472,100.

The liabilities section shows total liabilities of $247,000, which comprises total current liabilities and long-term debt.

The shareholders’ equity comprises common stock, retained earnings, additional paid-in capital, and treasury stock. Calculating shareholders’ equity, we get $225,100.

According to the balance sheet equation –

Assets = Liabilities + Shareholder’s Equity

$472,100 = $247,000 + $225,100

How Balance Sheets Work?

As we already discussed, the balance sheet shows an overview and snapshot of the company’s assets, liabilities, and equity. We now check how balance sheets work.

To understand the same, we again take the above-mentioned balance sheet formula:

Assets = Liabilities + Shareholder’s Equity

According to this formula, the values of assets, liabilities, and shareholders’ equity should be equal.

We now see how the balance sheet mechanism works step by step:

1. List the Assets

Predict every value that the business owns, including inventory, property, equipment, and cash. These assets are classified as long-term assets and current assets. However, the total assets will be the addition of long-term assets and current assets.

2. List all the Liabilities

Identify the values that the business owes, which cover accounts payable, taxes, loans, and salaries. Similar to assets, categorize these values as current liabilities and long-term liabilities. The total liabilities will be the sum of all the liabilities, including current and long-term liabilities.

3. Calculating Shareholders’ Equity

To determine the shareholders’ equity, you need to subtract liabilities from assets. This will cover retained earnings, common stock, and other additional investments.

4. Verify the Balance

In this step, verify that assets are equal to liabilities + equity.

Note: Apart from assets, liabilities, and equity, all the revenue and expenses will be removed when calculating.

Important Metrics to Consider When Calculating the Balance Sheet

Working Capital

The metric shows the amount of cash you will have when you have paid off all your debts. It represents operational efficiency and the company’s short-term financial health. Working capital is calculated by subtracting current liabilities from current assets.

Working Capital = Current Assets – Current Liabilities

Debt-to-Equity Ratio (D/E ratio)

A high D/E ratio indicates that a business needs a bank loan and other funds to maintain good financial health. This ratio is very helpful for investors and shareholders in deciding whether to raise money through debt or investment.

Return on Assets

Return on assets represents the profitability ratio of the amount of profit that a company is generating from its assets. This formula calculates the amount of net income being earned relative to the assets owned.

Return on Assets = Company’s Net Income/ Company’s Average Total Assets

Quick Ratio

It is also called an acid test ratio, and it describes your business’s capability to pay all short-term liabilities through cash and near-cash assets. Here, the core focus is on assets that are easy to liquidate instead of those that are hard to liquidate. Similarly, you don’t cover long-term investments, such as real estate.

Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable)/Current Liabilities

Current Ratio

The current ratio measures the liquidity of the company. A high ratio always indicates good financial health.

Current Ratio = Current Assets / Current Liabilities

An ideal current ratio is 2:1 or higher. This indicates that the company holds twice as much value in assets as it does in liabilities.

On the other hand, a 1:1 ratio is not a good sign and indicates that the company has a liquidity shortage to pay off the debt.

Debt-to-Equity Ratio

The debt-to-equity ratio measures the company’s relationship to debt. It is calculated by dividing the total liabilities by shareholders’ equity.

Debt to Equity Ratio = Total Outside Liabilities/Owner or Shareholders’ Equity

How to Make a Balance Sheet?

Creating a balance sheet involves identifying assets & liabilities and calculating shareholders’ equity. It doesn’t sound easy when professionals think about how to make a balance sheet. But it is not as difficult as professionals think. The process involves the following steps:

1. Identifying the Reporting Date & Period

The major purpose of the balance sheet is to outline the total assets, liabilities, and shareholders’ equity on a specific date, which is known as the reporting date. Often, this is the final day of the accounting period.

2. Identify Your Assets

The next step is determining the assets. The balance sheet presents assets in two ways: individual line items and total assets. The splitting and breakdown of assets ease an analyst’s understanding.

Current Assets

• Inventory
• Cash
• Short-term marketable securities
• Other current assets
• Accounts receivable

Non-Current Assets

• Property
• Goodwill
• Long-term marketable securities
• Other non-current assets

3. Identifying the Liabilities

Similar to identifying assets, the next move is identifying the liabilities. There will be current liabilities and non-current liabilities.

Current Liabilities:

• Accounts payable
• Deferred revenue
• Accrued expenses
• Other current liabilities

Non-current Liabilities:

• Long-term debt
• Other non-current liabilities
• Deferred revenue (non-current)

4. Calculating the Shareholders’ Equity

Calculating shareholders’ equity for a small company is simple because it has a single owner. However, this becomes complicated when there is a large enterprise. The equation to calculate equity is –

Equity = Total Assets – Total Liability

Some of the common line items in shareholders’ equity are as follows:

• Treasury stock
• Preferred stock
• Retained earnings
• Common stock

What Is the Purpose of a Balance Sheet?

The importance of balance sheets lies in the business world when professionals think about the purpose of a balance sheet. They are crucial financial documents that provide an overview of a company’s financial health. This document helps investors assess the company’s overall financial condition, which in turn helps them make the right investment decision and predict future growth.

Apart from this, using financial ratios, professionals can easily analyze the liquidity condition, cash flow condition, and capital funding. By analyzing all the financial aspects, it becomes easy to predict the number of daily transactions that your business can afford.

A clear and up-to-date balance sheet also helps companies acquire bank loans easily. Banks always check the balance sheet before lending to a company, which helps them predict whether the company is in a condition to repay the loan amount or not.

Overall, the importance & purpose of the balance sheet is for investors, bankers, and professionals.

Who Is Responsible for Preparing a Balance Sheet?

Preparing the balance sheet is not limited to a specific person or department. It depends upon the company’s size. For instance, a small-scale company owner can create a balance sheet by himself.

For mid-size companies, the internal accountant team can prepare the balance sheet and review it with the external accountant. In big enterprises, a dedicated accounting team or a finance department can create a balance sheet.

What Are the Common Mistakes to Avoid While Preparing a Balance Sheet?

While preparing a balance sheet, professionals should always be attentive. Mistakes could ruin your game.

Misclassification of liabilities and assets is one common mistake. Often, professionals mix current and non-current items, which gives rise to blunder mistakes.

Similarly, incorrect valuation is another problem. For instance, a professional may choose market value instead of book value. Also, professionals sometimes record incorrect transactions & statements that lead to discrepancies in the financial statements.

The best solution to this problem is to review the balance sheet transactions regularly. This helps to detect and rectify mistakes.

Verdict

The balance sheet acts as a presentor of your company’s capital. This document describes the financial status of your organization and helps you take the right steps to improve business liquidity and attract the right investors. Additionally, the business must create and maintain the right balance sheet with correct data.

Frequently Asked Questions