Understanding Balance Sheets
If you are running a business or you are considering investing in a company, understanding the business entity’s finances is crucial for success. Different financial statements are an essential part of getting to grips with the business’ finances. One of the financial statements you are likely to come across is a balance sheet.
This guide will walk you through (1) the definition of a balance sheet, (2) the main reasons you should use it and (3) tips for understanding and reading balance sheets. The guide will hopefully give you better tools for managing your business’ finances or investing in companies with a healthy financial background.
WHAT IS A BALANCE SHEET?
A balance sheet is simply a financial statement that summarizes key financial elements from a specific period. It looks at three elements of the entity’s finances, which are:
- Liabilities, and
- Shareholders’ equity
The three sections are a snapshot of what the entity owns as well as what it owes. It also tells how much shareholders have invested in the entity. Therefore, a balance sheet is often referred to as a snapshot of the entity’s financial condition.
As mentioned, the balance sheet typically looks at a specific point of time in the entity’s history. It is most often produced at the end of the entity’s financial year or the accounting year.
A balance sheet is often presented in the following formula:
Assets = Liabilities + Shareholders’ equity
Who needs a balance sheet?
A balance sheet can either be used to summarize the finances of a business organization or an individual. It is most commonly used for business purposes, either by corporations or other such business organizations or by a sole proprietorship or a business partnership.
If the balance sheet is for an individual or a small business, the format used is a bit simpler. For larger corporations and businesses, the balance sheet often lists more information. Furthermore, larger business entities might choose to prepare different balance sheets for different segments of the business.
What are the benefits of a balance sheet?
While a balance sheet is not normally a part of a business’ formal accounting statements, such as tax calculations, many businesses and individuals find it extremely useful. In short, a balance sheet is a great indicator of the business’ financial health.
Some of the key benefits of a balance sheet are tied around this understanding of the business’ financial health. The below are the main advantages of producing a balance sheet if you are running a business, whether it is a small or a large organization.
Overview of the business’ finances
As already mentioned, a balance sheet gives an important overview of the business’ financial position. More importantly, a balance sheet focuses on providing information on the business’ current asset situation and the liabilities it still has. Therefore, it provides further financial information to a typical profit or loss statement.
A balance sheet provides a more comprehensive picture because it looks at the future instead of just the current situation. For example, your profit or loss statement might show your business made a big profit in a given financial year. But the balance sheet will show whether you get to enjoy it or not, as you can see any incoming payments.
Important information to benefit investors
The above overview of business finances is naturally an essential aspect of how possible investors view your business. It can add much more information to investors’ decision-making process and decide whether to invest to the business or not.
Therefore, it can be a good way to attract investors to the business, as well as a crucial tool for investors. It is a good idea for the business to produce the balance sheet and present it to investors and other lenders in order to improve accountability and transparency.
Makes it easy to prioritize financial liabilities
Finally, as the balance sheet looks at the business’ current liabilities, it can help the entity to decide how to prioritize these. For example, you are able to see all the short-term debt commitments and make better decisions on whether you need to improve your business profits or perhaps even look into getting more investment.
THE BASICS OF A BALANCE SHEET
It is now time to turn attention to the key figures presented in the balance sheet and to look deeper into the formula behind a balance sheet. The section first looks at the personal balance sheet, which is often a simpler format to the business balance sheet, which will be dealt with later.
The simple, personal balance sheet
There are three sections to a personal balance sheet, just as in the more complex business balance sheet. The key parts of the personal balance sheet deal with assets, liabilities and the owners’ equity.
The assets of a personal balance sheet deal with current and non-current assets. Current assets include items such as checking accounts and savings accounts the individual or small business might have. It also lists long-term assets such as stock options and real estate.
Sometimes the different assets are divided into current and non-current assets. Non-current assets are mostly these fixed assets, such as real estate and other such equipment. Non-current assets are mostly assets that cannot be converted into cash in less than a year – meaning they are long-term assets.
For assets, such as real estate or stock securities, the value listed are always the current market value rather than a historical cost or cost basis value. This allows the asset value to be as accurate as possible.
Next the balance sheet will list any liabilities the individual or small business might have. Liabilities are the money the individual or business owes to outside parties, such as other suppliers, the banks and even the employees in the form of wages. These are again divided into current liabilities and long-term liabilities.
In the case of individual and small business owners, current liabilities include any loan debt the business has due, as well as mortgage debt.
On the other hand, long-term liabilities are often any mortgage or loan engagements, which are not due at the time of producing the balance sheet. As with long-term assets, the non-current liabilities refer to payments due at any point after one year.
The owners’ equity
Finally, the balance sheet will list any of the owners’ equity. The owners’ equity can also be referred to as personal net worth, if the balance sheet is for an individual instead of a small business.
The owners’ equity is calculated by subtracting the total liabilities from the total amount of assets. It is therefore the money the business or individual could take if they ceased to be.
A business balance sheet
The above balance sheet is a stripped down version of the business’ balance sheet, which often includes more assets and liabilities that might not be needed for a small business owner. The basics are the same in both balance sheets.
Here is a look at the three sections of a business balance sheet: assets, liabilities and the equity or capital of the business.
The assets are divided into two sections: the current assets and the non-current assets (fixed assets). Below is a list of items listed in both of these sections:
- Current assets:
- Cash and cash equivalents – these include most liquid assets of the company.
- Receivable accounts – the money the customers still owe to the company.
- Marketable securities – all equity as well as debt investments which have a liquid market.
- Inventory – goods the business currently has in stock ready to sell. These goods are listed with the current market price or lower.
- Prepaid expenses – the value that has been paid for, for example, in the case of insurance or rent.
- Long-term assets:
- Any long-term investments – these are investments that cannot be liquidated in the coming year.
- Fixed assets – land, machinery, equipment, and buildings, for example.
- Intangible assets – these represent assets that aren’t physical assets, but nonetheless, have value. Intellectual property, for example, would account as intangible asset. Notice that intangible assets like this are only listed in a balance sheet if the business acquires them.
Next the business balance sheet looks at the liabilities. Again, the section is very similar to a personal balance sheet, with the exception that a lot more liabilities are usually listed in the business format.
The business balance sheet makes the distinction between current and long-term liabilities. The following are the example items listed in both categories:
- Current liabilities:
- Current portion of long-term debt – as above, the amount that is due or overdue.
- Bank indebtedness
- Rent, tax and other utilities payments
- Wages the business has to pay
- Interest – for instance, interest payments on debt.
- Customer repayments – businesses might often need to repay an unhappy customer.
- Dividends payable to investors or shareholders
- Long-term liabilities:
- Long-term debt – the interest as well as principle on bonds the business might have issued.
- Pension fund liability – many companies have a setup payment system for employees’ retirement funds.
- Deferred tax liability – if there are any tax payments that have already been decided, but which won’t be payable for the next year, they are added into this section.
Not all liabilities are mentioned in the business balance sheet. For instance, operating leases are a liability, which won’t appear on the balance sheet.
Finally, the business balance sheet looks at the shareholders’ equity. These are also referred to as the net assets of the business. The shareholders’ equity is equivalent to the total assets of the business minus the total liabilities.
In the business balance sheet the equity section can often have a number of different figures. The most common option is to divide the equity into the following sections:
- Retained earnings – the net earnings the business uses to pay off its debt or used to reinvest in the business. The remaining is then distributed to shareholders in the form of dividend payments.
- Treasury stock – if the company has stock that it has either repurchased or never issued, it is listed here. It can be used to raise cash, prevent a hostile takeover or sold forward later on.
- Additional paid-in capital – the figure the shareholders have invested in common stock or the preferred stock, with the value based on par value instead of a market price.
In the formal sense, the shareholders’ equity is part of the business’ liabilities, as it is the equity the business ‘owns’ to its shareholders. Yet, liabilities are considered to be more restrictive and thus shareholders’ equity is considered residual.
An example balance sheet
In order to understand the visual presentation of a balance sheet, below is an example for you to use. There are naturally slight differences between the ways companies choose to present the information, but the example will give you a good understanding of the information discussed above.
· Accounts receivable $6,500
· Current accounts $2,300
· Wages $15,000
· Debt $1,200
· Tools $5,000
· Real estate $30,000
· Debt $15,000
Total liabilities $31,200
· Capital stock $10,000
· Retained earnings/dividend $2,600
Total owners’ equity $12,600
|Total $43,800||Total $43,800|
TIPS FOR INTERPRETING A BALANCE SHEET
Now that you understand the different aspects of the balance sheet and the benefits of having one, it is a good idea to look at how to best interpret a balance sheet. Keep in mind that just like with many other financial statements, it is often helpful to view and compare balance sheets from different periods. This provides you a better picture of how the business has been able to develop and manage its assets and liabilities over the years.
Here are some of the key tips and hints for making the most of the balance sheet.
Understanding the balance sheet formula
As mentioned at the start, a balance sheet uses a basic formula, which goes:
Assets = Liabilities + Shareholders’ equity
What this means is the assets the entity uses to operate are balanced with the financial obligations the company has together with the equity investment the company’s owners or shareholders make, as well as the earnings they take out. This means that the total amount of assets must always be the same as the liabilities and the equity added together.
Furthermore, the shareholders’ equity section can be calculated by taking the total amount of liabilities away from the total amount of assets.
If the balance sheet’s figures don’t add up, you can quickly tell that something is wrong with the figures listed in the balance sheet.
Get to grips with current and non-current assets
It also helps to understand the difference between current and non-current assets, as this can give deeper insight into the cash position of your company. Since current assets are assets that can be converted in a year or less into cash, a business with a healthy current asset section can easily counter any big debts or other such payments it might have.
In addition, since non-current assets can include non-physical assets such as patents or copyrights, you need to be careful with the valuation they receive. Since valuation of non-physical goods is harder, you need to ensure the figure on the balance sheet doesn’t over- or underestimate the value.
Furthermore, make sure depreciation is calculated and deducted from most of your non-current assets. For instance, machinery and other such tools will likely lose its value over time. Depending on the country, there are different accounting rules for depreciation.
Learn the differences between different liabilities
As well as understanding the differences between assets, you’ll also need to learn the difference between different liabilities. As current liabilities refer to payments that are due within a year or less, you want to make sure the entity has the cash to pay these. At the same time, you don’t want to keep growing the long-term liabilities for a long period.
Keep in mind that any interest payments you need to make from long-term debts is always under the current liabilities, even if the majority of the actual debt sits under long-term liabilities.
It is a good idea to check the current liabilities against the current assets. If your current liabilities are larger than your current assets, you are running into financial difficulties.
Analyze the balance sheet with ratios
Finally, for a deeper understanding of what the balance sheet is telling about the financial health of the business entity, you need to use financial ratio analysis. This means using different formulas to highlight the financial performance of the entity.
There are different types of ratios you can use. Some rations might even require you know certain information from other financial statements for the entity, such as the income statement.
The most basic financial ratio to use is the debt to equity ratio. This shows you the financial condition of the company and its operational efficiency. It can be calculated with the following formula:
Debt – Equity ratio = total liabilities/shareholders’ equity
You can find out more about the debt to equity ratio from the below YouTube video:
Other common ratios you can figure from the balance sheet are financial strength ratios and activity rations. Here are some of the formulas for calculating these figures:
Working capital = current assets – current liabilities
Quick ratio = (current assets – inventory) / current liabilities
Debt to total assets = total debt / total assets
The above ratios are just some of the main examples that help you better understand the balance sheet, as well as to use it for understanding the business entity’s finances better. Whether you are an investor or a business owner, understanding the balance sheet can help you make better financial decisions.
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