Understanding the Balance Sheet
A thorough understanding of the balance sheet can help investors and business owners make better financial decisions — which is why a review may be in order. A balance sheet is a financial statement that reports a company’s assets, liabilities and shareholders’ equity at a specific point in time. The statement shows what an entity owns (assets) and how much it owes (liabilities), as well as the amount invested in the business (equity). It is an indicator of the business’ financial health.
Assets are presented on one side of the balance sheet and liabilities plus shareholders’ equity on the other. Here is the accounting equation: Assets = Liabilities + Shareholders’ Equity. Investopedia describes the formula as being intuitive: a company must pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholders’ equity).
By itself, the balance sheet cannot provide insight on trends over a period time. Therefore, it should be compared with previous periods to gain information and benchmarks. Comparisons should also be made to similar companies in the geographic area to gain insight on how the company is doing.
The assets are divided into two sections: the current assets and the non-current assets (fixed assets).
Current assets include the following:
- Cash and cash equivalents — includes most liquid assets of the company
- Receivable accounts — money the customers still owe to the company
- Marketable securities — all equity as well as debt investments that have a liquid market
- Inventory — goods the business currently has in stock ready to sell listed with the current market price or lower
- Prepaid expenses — value that has been paid for expenses such as insurance or rent
- Long-term assets include the following:
- Any long-term investments — investments that cannot be liquidated in the coming year
- Fixed assets — assets such as land, machinery, equipment and buildings.
- Intangible assets — assets that are not physical assets but have value. Intellectual property, for example, is an intangible asset. Intangible assets like this are only listed on a balance sheet if the business acquires them.
The business balance sheet makes the distinction between current and long-term liabilities. Not all liabilities are included in the business balance sheet.
Current liabilities include the following:
- Accounts payable — amounts due to vendors that have supplied goods or services
- Deferred revenues — amounts a customer has prepaid and will be earned by the company within one year of the balance sheet date
- Accrued compensation — payroll due to employees and to be remitted for payroll taxes
- Other accrued expenses — amounts owed for items not recorded in accounts payable or accrued compensation
- Accrued income taxes and some deferred income taxes
- Short-term notes — loans from banks that will become due within one year
- Current portion of long-term debt — principal payments of a mortgage loan or an equipment loan that must be paid within one year
- Dividends payable to investors or shareholders
Long-term liabilities include the following:
- Long-term debt — interest and principal on bonds the business might have issued
- Pension fund liability — payments for employees’ retirement funds
- Deferred tax liability — tax payments that will not be payable for the next year or later
The equity section is commonly divided into the following sections:
- Capital stock (original)
- Retained earnings — net earnings the business uses to pay off its debt or reinvest in the business. The remaining is then distributed to shareholders in the form of dividend payments.
- Treasury stock — stock that the company has either repurchased or never issued. It can be used to raise cash or prevent a hostile takeover, or it can be sold.
- Additional paid-in capital — common stock or preferred stock in which shareholders have invested. The value is based on par value instead of a market price.
The shareholders’ equity section can be calculated by taking the total amount of liabilities away from the total amount of assets.
A financial ratio analysis can be used to gain a deeper understanding of the balance sheet. The most common ratios used to determine a company’s financial health include the following:
- Debt-to-equity ratio = total liabilities / shareholders’ equity
- Working capital = current assets - current liabilities
- Quick ratio = (current assets - inventory) / current liabilities
- Debt to total assets = total debt / total assets
Thus, the balance sheet provides an idea of the company’s financial position, indicates whether the business is profitable and helps to determine what actions, if any, need to be taken to improve the company’s performance.
This article appeared in the November/December 2020 issue of New Jersey CPA magazine. Read the full issue.