What Is a Balance Sheet? FAQs, Components, and an Example
By Indeed Editorial Team
Updated November 14, 2022 | Published October 18, 2021
Updated November 14, 2022
Published October 18, 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
When preparing financial statements for a company, ownership, management, and stakeholders use several vital documents to assess the organization. One of these documents is a balance sheet. Understanding what a balance sheet includes and why it's an important document can help you better evaluate the financial health of an organization. In this article, we discuss the definition and purpose of a balance sheet, identify the information included and excluded on this financial document, and highlight ways to analyze and read a balance sheet along with an example.
What is a balance sheet?
A balance sheet is a financial statement that provides a snapshot of an organization's fiscal health at a point in time. It includes information about the assets, liabilities, and shareholder equity or investment in the business. An asset is what an organization owns, whereas a liability is what it owes to others. Balance sheets are one of three critical documents used to determine the financial status of a company. The other two crucial reports are cash flow statements and income statements.
What is the purpose of a balance sheet?
The purpose of a balance sheet is to provide information to internal and external stakeholders regarding the organization's financial health. The information contained within the balance sheet can also provide lenders or investors with data to decide whether to provide lending or additional funds to the company. In addition, investors use balance sheets as one tool to calculate rates of return for their potential investment. Finally, together with other critical financial statements, banks and lenders use the information to conduct an economic analysis of the organization or calculate financial ratios.
What information does a balance sheet include?
There are three principal areas of information on a balance sheet that include assets, liabilities, and shareholder equity:
On financial statements, such as balance sheets, assets are the organization's resources that represent value. For example, assets include property, equipment, inventory, and cash. In addition, assets help generate cash flow through manufacturing equipment or reducing expenses, such as owning land and buildings. A balance sheet lists an organization's asset accounts from top to bottom in order of their liquidity. Liquidity refers to the ease with which a company can convert an asset into cash. There are two primary types of assets listed on a standard balance sheet:
Current assets have a short life span of a year or less. Existing assets, such as inventory, list on a balance sheet at their historical cost. An auditor or financial controller can occasionally evaluate their worth and adjust values based on qualifiers, such as ageing or improvements. They include items of values that can convert to cash within a short period, such as:
Cash or cash equivalents, such as a cash register float or short-term investments
Inventory that is for sale
Prepaid expenses, such as building insurance paid annually
Accounts receivable, which is the amount of money that customers or clients owe the business
Long-term assets have a longer life span and expect to exist after more than a year. A long-term asset also takes longer to liquidate into cash if needed. Some non-current assets take depreciation into account when evaluating their value, such as property or equipment. Other assets, such as patents, trademarks, or client base, rely on the perception of value and potential earnings due to their ownership. Long-term assets include:
Fixed assets, such as property, buildings, land, equipment, and vehicles
Long-term investments that cannot convert into cash for a considerable period
Intangible assets, such as trademarks, patents, copyrights, and goodwill
A liability is anything that an organization owes to others. This includes money due to suppliers for inventory, rent and utilities, and employee salaries. As an accounting concept, liabilities are not inherently harmful, as they allow for business expansion and growth without paying for all costs upfront. On a balance sheet, you list liabilities on the right side in two separate categories on current and long-term liabilities:
Current liabilities have a short life span, and the company pays them within a year or less. You usually list current liabilities in order of their due date. Some examples include:
Existing portions of long-term debts
Employee salaries and wages
Accounts payable, such as money owed to suppliers for inventory purchased
Interest payable on loans and credit
Long-term liabilities have a longer life span, and an organization expects them to remain a debt for over a year. Examples of long-term liabilities can include:
Long-term loans or credit
Pension obligations or post-employment benefits
Deferred income tax
The last piece of information included on a balance sheet is shareholder equity. Shareholder equity, also called owner equity, is the amount of money available to the company's ownership after the organization pays out all liabilities. Accounting also refers to net assets, which they calculate by subtracting liabilities from assets to determine the remaining amount. Corporations use the terms "shareholders' equity" or "stockholders' equity," which sole proprietorships use "owners' equity."
When listing out shareholder equity on a balance sheet, there are typically five different types used:
Retained earnings are the net earnings that are reinvested or used to pay off debts. The company divides the remaining amount to shareholders as dividends.
Treasury stocks are company stocks repurchased by the organization.
Preferred and common stocks are shares representing ownership in the company.
Paid-in capital, which is the amount of money or other assets company shareholders have contributed in exchange for stock.
What does a balance sheet not include?
One of the most critical pieces that a balance sheet doesn't include is an opportunity to compare information from different periods or over time. Because it is only a snapshot of the financial health at the time of the report, you need other statements to help you make comparisons. For this purpose, you can look at a cash flow statement or an income statement.
Another limitation of a balance sheet is the process of handling depreciation and inventory costs. Different accounting methods have various ways of calculating depreciation on fixed assets. This also includes the representation of inventory costs on a balance sheet. For this reason, be sure to read any footnotes on the balance sheet to understand the process used.
Who prepares a balance sheet?
The individual preparing the balance sheet depends on the organization. For a sole proprietorship or small privately owned business, the owner or company bookkeeper typically prepares the balance sheet when they complete their monthly financial statements. For medium-sized companies, often the company accountant or financial controller can prepare the balance sheet. Public companies and corporations require external financial audits. Because of this, the corporation's controller can prepare the financial statements and then have an external accountant review them.
Reading a balance sheet
When you read a balance sheet, you may notice that they split the information into two parts. On the left side is the list of assets with the most easily liquidated assets listed first, with more difficult liquidated assets listed below. On the right side of the paper is the list of liabilities, starting with current followed by long-term. For a proper balance sheet to balance, these two sections must equal each other using the following formula:
Assets = liabilities + owners' equity
It's critical that the two sections are equal; otherwise, there is a mistake in the calculations, such as forgetting to record a transaction or recording a transaction improperly. The assets of the business use the liabilities, or borrowed money, and the shareholder's equity to operate the company.
Related: What Is a Financial Controller?
Standard financial ratios to analyze balance sheets
Once you feel comfortable with the information presented on a balance sheet, you can use specific ratios to analyze the data further. There are two common financial ratios you can use to analyze a balance sheet that includes:
A debt-to-equity ratio determines how much debt a company uses to finance its operations versus the organization using its own money. This ratio evaluates the company's financial leverage. When calculating this ratio, a higher ratio shows a higher risk for stakeholders. You can calculate the debt-to-equity ratio using this formula:
Debt-to-equity ratio = total liabilities / total equity
Working capital ratio
The working capital ratio measures a company's ability to pay its liabilities, or debts, with its current assets. This is a critical calculation to determine an organization's financial health. Many lenders or creditors look at this ratio to assess a company's ability to meet its financial obligations and pay off its debts within a year. You can calculate the working capital ratio using this formula:
Working capital ratio = current assets / current liabilities
What does a balance sheet look like?
Below is an example of what a basic balance sheet looks like:
True North Manufacturing Ltd.
September 30, 2021
Balance Sheet True North Manufacturing Ltd. September 30, 2021
Current Assets Current Liabilities
Petty cash $5,200 Accounts payable $12,000
Bank accounts $25,000 Wages and salaries $4,600
Inventory $6,500 Prepaid insurance $2,500
Accounts receivable $2,000
Total Current Assets
$41,200Total Current Liabilities**$16,600**Non-Current Assets
Equipment$60,000Long-term loans$35,000Land and building$125,000Mortgage$125,000Total Non-Current Assets**$185,000**Total Long-Term Liabilities**$160,000**Total Assets**$226,200**Total Liabilities**$176,600**
Total Owner's Equity**$49,600**Total Assets**$226,200**Total Liabilities and Equity**$226,200
Please note that none of the companies mentioned in this article are affiliated with Indeed.
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