What is The Balance Sheet?
A balance sheet denotes a clear and concise statement of a firm’s total assets, liabilities, and net worth. It offers an exact explanation of a company’s financial position at a given point in time. Balance sheets are generally prepared at the end of the month, quarter, or year-end by the accounting experts of a company. The overall financial health of a business, including assets, liabilities, and net wealth is represented via a balance sheet. This concise statement has got its name as a balance sheet because of the belief that the company assets minus liabilities should always equal the owner’s total equity (they should balance).
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Key Elements of A Balance Sheet
There are three major parts of a balance sheet that helps in identifying the total assets or liabilities of a company at a given time. These three major components include Assets, Liabilities, and Owner’s Equity.
Assets
Assets in the balance sheet refer to the valuable own by a company for profit or income generation. These are also resources that have a high futuristic value for the company and can be divided into two parts- tangible assets and intangible assets.
Tangible assets have further subcategories- current, long-term, and other assets.
Current Assets: comprise of cash, prepaid expenses, accounts receivable, and all other items/resources eligible for cash conversion within a year.
Long Term Assets: are also known as fixed assets. When compared to current assets, these types of assets are long-term revenue generation sources for firms. All fixed assets, barring land are shown on the balance sheet at their original cost as it is a non-depreciating asset.
Non-tangible assets, on the flip side, are the ones that don’t have any physical existence but work as long-term virtual assets for a company. Companies use non-tangible assets for more than one year and include items like a trademark, copyrights, patents, goodwill, etc.
Liabilities
Liabilities are the legal, financial debts or obligations that need to be paid or fulfilled by the company. These are claims of the creditors put against the company assets. These financial obligations generally arise due to the company’s past or current transactions.
Liabilities are broadly classified into two categories-current and long-term liabilities.
Current liabilities are also known as short-term liabilities and include the debts which have to be cleared within a year by a company. Current liabilities include accounts payable, interest payable, income taxes payable, accrued expenses, bills payable, etc.
Long-term liabilities, on the other hand, denotes the debts that must be repaid by companies in more than one year from the date given in the balance sheet.
Net Worth (Owner’s Equity)
Owner’s equity (sometimes referred to as the sole proprietorship or net worth) denotes the book value of the company because it equates to the amount, which is equal to the reported asset minus the reported liability.
Assets – liabilities = Net Worth
The balance remaining after the liabilities are subtracted from the assets of a particular business is known as the net worth.
The net worth section in the balance sheet include items like
- Paid-up capital
- Retained earnings
- Treasury stock
Preparing a Balance Sheet
The Two most common formats for balance sheet reporting are:
- The vertical balance sheet (all line items are presented on the left side of the page)
- The horizontal balance sheet (where asset line items are listed down the first column whereas liabilities & equity line items are listed in a later column)
Among these two, the vertical format is more popular & easy to use when information is being presented for multiple periods.
Balance Sheet Example:
What Can be Identified From The Balance Sheet Analysis?
- The overall financial health of a company at a given time point.
- The amount of capital held by a business
- The solvency, productivity, and growth of a business
Pros of Balance Sheet Reporting
Business Valuation
You can get an accurate picture of the business status or determine its value at a given point in time by analyzing the balance sheet of a company.
The balance sheet also provides a detailed idea regarding the financial debts that must be paid by business owners to their investors. It provides an idea regarding bills that need to be paid to the vendors by a particular business.
Quick Decision Making:
Every balance sheet is unique as it provides critical information to businesses for their future financial planning whereas investors can use this information in conjunction with other financial documents, i.e., cash flow statement, etc. to decide whether to invest in a particular company or not. Balance sheets also indicate a company’s ability to collect & pay debts on time. With the help of such balance sheet data, one can make a quick decision about the company’s risk and return prospects. For a trial, one can have Gen balance sheet software free download demo to prepare their balance sheet.
Easy Calculation of Financial Ratios
The long-term profitability and short-term financial outlook of a company can be easily determined by calculating the financial ratios through balance sheets,
For popular financial ratios like
- Current ratio
- Quick ratio
- Working Capital
- Debt/Worth Ration
can be easily calculated using the information from the balance sheet. These ratios help obtain a very concise summary of the company’s financial health by analyzing its cash position, working capital, liquidity, and leverage.
A company’s chances of defaulting on its credit obligations or even its bankruptcy risk-related insights can easily be obtained from these financial ratios derived through balance sheets.
Cons of Balance Sheet Reporting
Misleading Data or Numbers:
Balance-sheet are perfect for getting an on-point financial summary or snapshot of the business at a given time point, but at the same time, they can mislead potential investors.
For example, you, as an investor might get faux by a balance sheet analysis, indicating a high cash position of a company at the year-end, i.e., high reserves. But, in reality, it might be possible that the company is planning to distribute it in the form of dividends.
The True Value of Assets is Underexposed:
The true value of the assets is underexposed in balance sheets as they are reported at the historical costs. The current market valuation is generally neglected.
Other Limitations:
Some of the current assets of a company in a balance sheet are mostly valued on an estimation basis. Hence, the true financial position of the business can’t be measured directly from the balance sheet. We also see a complete exclusion of the valuable non-monetary assets of a company in its balance sheet, which is not good for accurate financial analysis.
Conclusion
So, overall, a Balance-sheet is an important financial document that helps business owners make sound & knowledgeable financial decisions. When used alongside other important financial documents like Profit and Loss Statement, Cash Flow Statement, etc., one can easily decide whether to invest in a particular business or not.
