BALANCE
SHEET A
balance sheet, also known as a
"statement of financial position",
reveals a company's
assets,
liabilities and owners' equity (net
worth). The balance sheet, together with
the
income statement and cash flow
statement, make up the cornerstone of
any company's financial statements. If
you are a shareholder of a company, it
is important that you understand how the
balance sheet is structured, how to
analyze it and how to read it.
How the
Balance Sheet Works
The balance sheet is divided into two
parts that, based on the following
equation, must equal each other, or
balance each other out. The main formula
behind balance sheets is:
Assets = Liabilities +
Shareholders' Equity |
This means that
assets, or the means used to operate the
company, are balanced by a company's
financial obligations along with the
equity investment brought into the
company and its retained earnings.
Assets are what a company uses to
operate its business, while its
liabilities and equity are two sources
that support these assets. Owners'
equity, referred to as
shareholders' equity in a publicly
traded company, is the amount of money
initially invested into the company plus
any
retained earnings, and it represents
a source of funding for the business.
It is important to note that a balance
sheet is a snapshot of the company’s
financial position at a single point in
time. (To learn more about reading
financial statements, see
What You Need To Know About Financial
Statements,
What Is A Cash Flow Statement?
and
Understanding The Income Statement.)
Know the Types
of Assets
-
Current Assets
Current assets have a life span of
one year or less, meaning they can
be converted easily into cash. Such
assets classes include
cash and cash equivalents,
accounts receivable and
inventory. Cash, the most
fundamental of current assets, also
includes non-restricted bank
accounts and checks. Cash
equivalents are very safe assets
that can be readily converted into
cash; U.S.
Treasuries are one such example.
Accounts receivables consist of the
short-term obligations owed to the
company by its clients. Companies
often sell products or services to
customers on credit; these
obligations are held in the current
assets account until they are paid
off by the clients. Lastly,
inventory represents the raw
materials, work-in-progress goods
and the company’s finished goods.
Depending on the company, the exact
makeup of the inventory account will
differ. For example, a manufacturing
firm will carry a large
amount of raw materials, while
a retail firm caries none. The
makeup of a retailer's inventory
typically consists of goods
purchased from manufacturers and
wholesalers.
-
Non-Current
Assets
Non-current assets are assets that
are not turned into cash
easily, are expected to be turned
into cash within a year and/or have
a life-span of more than a year.
They can refer to
tangible assets such as
machinery, computers, buildings and
land. Non-current assets also can be
intangible assets, such as
goodwill,
patents or copyright. While
these assets are not physical in
nature, they are often the resources
that can make or break a company -
the value of a brand name, for
instance, should not be
underestimated.
Depreciation is calculated and
deducted from most of these assets,
which represents the economic cost
of the asset over its
useful life.
Learn the
Different Liabilities
On the other side of the balance sheet
are the liabilities. These are the
financial obligations a company owes to
outside parties. Like assets, they can
be both current and long-term.
Long-term liabilities are debts and
other non-debt financial obligations,
which are due after a period of at least
one year from the date of the balance
sheet.
Current liabilities are the
company’s liabilities which will come
due, or must be paid, within one year.
This is includes both shorter term
borrowings, such as accounts payables,
along with the current portion of longer
term borrowing, such as the latest
interest payment on a 10-year loan.
Shareholders'
Equity
Shareholders' equity is the initial
amount of money invested into a
business. If, at the end of the fiscal
year, a company decides to reinvest its
net earnings into the company (after
taxes), these retained earnings will be
transferred from the
income statement onto the balance
sheet into the shareholder’s equity
account. This account represents a
company's total net worth. In order for
the balance sheet to balance, total
assets on one side have to equal total
liabilities plus shareholders' equity on
the other.
Read the Balance
Sheet
Below is an example of a balance sheet:
As you can see
from the balance sheet above, it is
broken into two sides. Assets are on the
left side and the right side contains
the company’s liabilities and
shareholders’ equity. It is also clear
that this balance sheet is in balance
where the value of the assets equals the
combined value of the liabilities and
shareholders’ equity.
Another interesting aspect of the
balance sheet is how it is organized.
The assets and liabilities sections of
the balance sheet are organized by how
current the account is. So for the asset
side, the accounts are classified
typically from most liquid to least
liquid. For the liabilities side, the
accounts are organized from short to
long-term borrowings and other
obligations.
Analyze the
Balance Sheet With Ratios
With a greater understanding of the
balance sheet and how it is constructed,
we can look now at some techniques used
to analyze the information contained
within the balance sheet. The main way
this is done is through financial ratio
analysis.
Financial ratio analysis uses formulas
to gain insight into the company and its
operations. For the balance sheet, using
financial ratios (like the
debt-to-equity ratio) can show you a
better idea of the company’s financial
condition along with its operational
efficiency. It is important to note that
some ratios will need information from
more than one financial statement, such
as from the balance sheet and the income
statement.
The main types of ratios that use
information from the balance sheet are
financial strength ratios and activity
ratios. Financial strength ratios, such
as the
working capital and debt-to-equity
ratios, provide information on how well
the company can meet its obligations and
how they are leveraged. This can give
investors an idea of how financially
stable the company is and how the
company finances itself. Activity ratios
focus mainly on current accounts to show
how well the company manages its
operating cycle (which include
receivables, inventory and payables).
These ratios can provide insight into
the company's operational efficiency.
There are a wide range of individual
financial ratios that investors use to
learn more about a company. (To learn
more about ratios and how to use them,
see our
Ratio Tutorial.)
Conclusion
The balance sheet, along with
the income and cash flow statements, is
an important tool for investors to gain
insight into a company and its
operations. The balance sheet is a
snapshot at a single point in time of
the company’s accounts - covering its
assets, liabilities and shareholders’
equity. The purpose of the balance sheet
is to give users an idea of the
company’s financial position along with
displaying what the company owns and
owes. It is important that all investors
know how to use, analyze and read this
document.
To read more on balance sheets, see
Breaking Down The Balance Sheet,
Introduction To Fundamental Analysis and
How are a company's financial statements
connected?
|