A balance sheet is the statement of financial position of a business organization on a given date. It shows the financial position of a business which helps stakeholders in analysing its future prospects.
The topics discussed in this article are:
1. What is a Balance Sheet?
A balance sheet is a financial statement which summarizes the assets, liabilities, and shareholders’ equity of a business organization at a given date . It provides a base on which rate of return can be computed and its capital structure can be evaluated. It is also known as the statement of financial position.
The balance sheet is one of the three major financial statements, income statement and cash-flow statement, which are necessary for conducting a fundamental analysis of the business and calculating its financial ratios.
A balance sheet can only represent the financial position of a business at a given date. It cannot present varying trends over a longer time period. This is why a comparison of the balance sheet with different time periods and the business’ competitors is necessary to understand the various approaches to financing effectively.
2. Objectives of a Balance Sheet
The main purpose of a balance sheet is to analyze the financial position of a business. It also proves beneficial to the investors and creditors of the business. It informs them about what the business owns and owes at a given date . This information helps them to decide whether they should invest in the business or not. Interested parties may include business’ managers, current investors, potential investors, competitors, customers, suppliers, labor unions, government agencies, etc.
A balance sheet also helps derive various ratios such as equity-debt ratio, acid-test ratio, etc. These help investors understand the financial health of the business.
3. Base Formula of a Balance Sheet
The main formula of a balance sheet is:
Assets = Liabilities + Shareholders’ Equity
This means that a business is required to pay for all that it owns (assets) either by taking loans (liabilities) or by taking money from its owners (shareholders’ equity).
4. Segments of the Balance Sheet
Assets are the things of value which are owned by the business organization. They are listed in accounts in descending order of their liquidity. There are two types of assets – current assets (can be converted to cash in a year or less) and non-current or long-term assets (can be converted to cash in more than a year).
- Current Assets:
- Cash and its equivalents
- Marketable securities
- Accounts receivable
- Prepaid expenses
- Non-Current Assets:
- Fixed assets such as land, machinery, buildings, etc.
- Intangible assets such as intellectual property, goodwill, etc.
Liabilities are the things which the business owes to other parties. They include bills payable, interests, debts, outstanding rent , outstanding salaries , etc. They are listed in accounts in descending order of their due date. There are two types of liabilities – current liabilities (which are due within a year or less) and non-current or long-term liabilities (which are due in more than a year).
- Current Liabilities:
- Short-term debt or current payable amount of long-term debt
- Bank loans
- Payable interest
- Expenses on utilities, taxes, rents, etc.
- Salaries payable
- Customer prepayments
- Payable dividends
- Non-Current Liabilities:
- Long-term debt and its interest
- Liability of pension funds for employee retirement accounts
- Deferred tax liability
c. Shareholders’ Equity
Shareholders’ equity is the amount of money which belongs to the shareholders or owners of the business.
- Net earnings, like retained earnings, are reinvested by the business or used for paying debt. The rest is distributed as dividends to shareholders.
- Treasury stock
- Preferred stock
- Capital surplus
5. Notes to Accounts
Notes to accounts of financial statements consist of details related to the information mentioned in the main body of financial statements. These notes (or footnotes) inform of important accounting policies, company’s commitments, breakdown of sales, breakdown of purchases, details of assets and liabilities, potential profits and losses, etc. The information provided by notes to accounts is critical for concisely understanding and evaluating the financial statements of the company.
Investors who only focus on the main body of financial statements and oversee the notes commit a grave blunder as they can be easily misled that way. The notes may be several pages long but they are not to be undervalued while analyzing financial statements of a business. Therefore, a good way to read financial statements is from bottom to up and from back to front.