Balance Sheet

Rafat Abushaban

- Finance #  O 3.9K views   اقرأ بالعربية

Summary: A Balance Sheet represents assets, liabilities and shareholders' equity in a company, and offers a financial statement to understand and evaluate its financial structure. It is also known as "statement of net worth" or "statement of financial position"

A Balance Sheet is an important financial statement that is used to evaluate the returns and financial structure for a company. It revolves around identifying three main areas in the financial structure:

  • Assets
    Assets represent what the company owns; such as trucks, plants, machinery, and so on.
     
  • Liabilities
    Liabilities are owed by a company; such as rent, utilities, taxes, loans, and so on.
     
  • Shareholders' Equity or Capital
    This represents issued capital attributable to shareholders of the company.
     

What it looks like


From its name, A Balance Sheet should have two sides that are in balance so that it can be correctly read and digested. The balance happens depending on the following equation:

AssetsLiabilities + Equity

balance sheet

Assets


Assets are divided into two subsections:

  • Current Assets
    It refers to assets that can be transferred to (financial) liquidity through the short term and without a lot of effort. The following elements are commonly found in this section:
     
    • Cash and cash equivalents: Most liquid assets including cash in the bank, and checks.
    • Accounts receivable: Money that clients owe a business, and that should be paid back to the business in the short term.
    • Stock (inventory): If the business has an inventory of physical goods, it can be sold and turned into liquidity.  
    • Short-term investments: Stocks and other forms of investment that a business may have from investing in other commercial activities. Such stock can be sold and turned into cash relatively easily.
  • Fixed/ Long-term Assets
    It refers to long-term and fixed assets that need time and effort to be converted into liquidity. The following elements are commonly found in this section:
     
    • Long-term investments: Investments that cannot be sold within one year, and need more time to realize liquidity.
    • Business assets (Fixed): Includes buildings, real-estate, and the like.
    • Business tools (Fixed): Includes machinery, equipment and tools used by the company to create goods and services. Note that tools qualify as fixed assets only when the company uses them in production and within its operation. If the company sells these tools as products directly to customers, then they become current assets.
    • Other intangible assets: Non-physical objects such as intellectual property (IP) and copyrights.

Liabilities and Owner's Equity


These are clarified as follows:

  • Current Liabilities
    Similar to current assets, current liabilities constitute a burden on the company to pay in the short term, such as:
     
    • Accounts payable: Money that the business should pay to other businesses or entities in return for purchasing equipment or services.
    • Loans (short-term): Money that the business owes to lenders and banks, which is due within a year.
    • Taxes (short-term): Annual governmental standard taxes.
  • Long-term Liabilities
    Long-term liabilities that can be deferred at the present time, such as:
     
    • Long-term loans: Money that the business owes to lenders and banks, which is can be paid back throughout multiple years.
    • Other long-term liabilities, such as deferred taxes.
  • Owner's Equity (Shareholders Equity)
    Since the equation must be balanced, the difference between assets and liabilities will appear in the equity section. Meaning, if assets increase, the surplus is deposited in the capital and profits, which are distributed to shareholders. In the event that assets are less than liabilities, this will eat up capital or reduce shareholders' profits. In the balance sheet, this is interpreted as follows:
     
    • Capital: Money that forms the financial capital of the company.
    • Earnings withheld: Companies can choose either to disperse annual returns back to shareholders or withhold them. In case these earnings where withheld, they appear in this section.
    • Other elements that may directly affect equity.

Why are balance sheets useful?


A balance sheet can give a clear idea on a number of key financial indicators in a business:

  • Liquidity
    When comparing assets to liabilities, this gives an insight on business liquidity. Understand how much cash is readily available helps plan for the long-term and find ways to cover short-term commitments.
  • Efficiency
    Comparing how a business manages its assets and liabilities from year to year gives an idea on how efficient it operates.This is done by keeping an eye on keeping assets always larger than liabilities (otherwise the business will lose money), and utilize how the business is using its sources to generate revenue and how this can be further improved on.
  • Leverage
    Leverage of a business can be understood when looking at debt and equity. Things signals if a businesses is financing its operations from loans or investments, and thus how much risk it presents.
  • Rates of Return
    The balance sheet can be used to evaluate the rate of return, which measures how it generates returns, by comparing assets, liabilities, and equity.

Can balance sheets give a clear idea on the financial standing of a business?


While it gives a good idea on a business's financial health, the balance sheet provides limited information in a certain point of time. In order to have a clearer understanding of a business finances, one should look also at Business Cash Flow and other documents for a deeper insight.

Applicable example on balance sheets


The following example shows how a balance sheet looks like in general using a virtual example for a balance sheet for a business. You can download in excel format below. Here, we have a sample business (Bright Lights Co.)'s balance sheet comparing years 2020 with 2019.

balance sheet sample

We can see in this example that the total assets in 2020 ($240K) equals the total liabilities and equity ($240K). The same goes for 2019 ($270K).

To properly read the Bright Light's balance sheet, we want to look at individual rows and compare them between the years to understand how the business is doing. For example, we note that the stock of 2020 (30K) is less than in 2019 (50K), which means that the business don't have as much stock in the warehouses as it did last year. Also, we note a decrease in company assets from 150K to 100K, which may signal that Bright Light has sold of a building of its own during the past year.

Does this mean that the company is losing money? not necessarily. Take a look at the capital row and you will note an increase in capital from 200K to 210K, (given less earnings in 2020).

From this, we note that the balance sheet gives us a clearer idea on business progression, but does not simply summarize financial performance on its own. Other tools are often used by investors and financial experts alongside the balance sheet to give a clearer idea.


Click file to download