The term balance sheet refers to a financial statement that reports a company's assets, liabilities, and shareholder equity at a specific point in time. Balance sheets provide the basis for computing rates of return for investors and evaluating a company's capital structure.
In short, the balance sheet is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders. Balance sheets can be used with other important financial statements to conduct fundamental analysis or calculate financial ratios.
The balance sheet provides an overview of the state of a company's finances at a moment in time. It cannot give a sense of the trends playing out over a longer period on its own. For this reason, the balance sheet should be compared with those of previous periods.1
Investors can get a sense of a company's financial wellbeing by using a number of ratios that can be derived from a balance sheet, including the debt-to-equity ratio and the acid-test ratio, along with many others. The income statement and statement of cash flows also provide valuable context for assessing a company's finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet.1
The balance sheet adheres to the following accounting equation, with assets on one side, and liabilities plus shareholder equity on the other, balance out:
\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}Assets=Liabilities+Shareholders’ Equity
This formula is intuitive. That's because a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholder equity).
If a company takes out a five-year, $4,000 loan from a bank, its assets (specifically, the cash account) will increase by $4,000. Its liabilities (specifically, the long-term debt account) will also increase by $4,000, balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholder equity. All revenues the company generates in excess of its expenses will go into the shareholder equity account. These revenues will be balanced on the assets side, appearing as cash, investments, inventory, or other assets.
Balance sheets should also be compared with those of other businesses in the same industry since different industries have unique approaches to financing.
As noted above, you can find information about assets, liabilities, and shareholder equity on a company's balance sheet. The assets should always equal the liabilities and shareholder equity. This means that the balance sheet should always balance, hence the name. If they don't balance, there may be some problems, including incorrect or misplaced data, inventory or exchange rate errors, or miscalculations.1
Each category consists of several smaller accounts that break down the specifics of a company's finances. These accounts vary widely by industry, and the same terms can have different implications depending on the nature of the business. But there are a few common components that investors are likely to come across.
Components of a Balance Sheet
Accounts within this segment are listed from top to bottom in order of their liquidity. This is the ease with which they can be converted into cash. They are divided into current assets, which can be converted to cash in one year or less; and non-current or long-term assets, which cannot.
Here is the general order of accounts within current assets:
Cash and cash equivalents are the most liquid assets and can include Treasury bills and short-term certificates of deposit, as well as hard currency.
Marketable securities are equity and debt securities for which there is a liquid market.
Accounts receivable (AR) refer to money that customers owe the company. This may include an allowance for doubtful accounts as some customers may not pay what they owe.
Inventory refers to any goods available for sale, valued at the lower of the cost or market price.
Prepaid expenses represent the value that has already been paid for, such as insurance, advertising contracts, or rent.
Long-term assets include the following:
Long-term investments are securities that will not or cannot be liquidated in the next year.
Fixed assets include land, machinery, equipment, buildings, and other durable, generally capital-intensive assets.
Intangible assets include non-physical (but still valuable) assets such as intellectual property and goodwill. These assets are generally only listed on the balance sheet if they are acquired, rather than developed in-house. Their value may thus be wildly understated (by not including a globally recognized logo, for example) or just as wildly overstated.
A liability is any money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds issued to creditors to rent, utilities and salaries. Current liabilities are due within one year and are listed in order of their due date. Long-term liabilities, on the other hand, are due at any point after one year.
Current liabilities accounts might include:
Current portion of long-term debt is the portion of a long-term debt due within the next 12 months. For example, if a company has a 10 years left on a loan to pay for its warehouse, 1 year is a current liability and 9 years is a long-term liability.
Interest payable is accumulated interest owed, often due as part of a past-due obligation such as late remittance on property taxes.
Wages payable is salaries, wages, and benefits to employees, often for the most recent pay period.
Customer prepayments is money received by a customer before the service has been provided or product delivered. The company has an obligation to (a) provide that good or service or (b) return the customer's money.
Dividends payable is dividends that have been authorized for payment but have not yet been issued.
Earned and unearned premiums is similar to prepayments in that a company has received money upfront, has not yet executed on their portion of an agreement, and must return unearned cash if they fail to execute.
Accounts payable is often the most common current liability. Accounts payable is debt obligations on invoices processed as part of the operation of a business that are often due within 30 days of receipt.