A balance sheet plays a significant role in creating a business’s financial statements. However, there are many components and elements to consider when making a balance sheet. It must be balanced; otherwise, it will not reflect the company’s financial position. This article provides detailed information to help you thoroughly understand a balance sheet, its uses, and its components.
Understanding a balance sheet and its components is crucial to ensuring it depicts the true financial position. If you need outside assistance with this, you can reach out to our professional team at 1-855-546-5024, and they will help you clear all your doubts on a balance sheet.
Balance Sheet – A Brief Overview
A balance sheet is a financial statement that reports a business’s assets, liabilities, and shareholder equity at a specific point in time. Balance sheets act as the basis for computing rates of return for investors and are used to evaluate the capital structure. It serves as a reference document for investors and other stakeholders and helps determine an organization’s financial health. By studying a balance sheet, stakeholders can compare current assets and liabilities, determine the business’s liquidity, calculate the rate of return, etc. Comparing two or more balance sheets from different time periods can help understand how the business has grown over time.
For example, the balance sheet can be used to prove creditworthiness while applying for business loans. By seeing whether current assets are greater than current liabilities, creditors can determine if the company can fulfill its short-term obligations. It helps understand how much financial risk the company is taking. Balance sheets can be used with other important financial statements to calculate different financial ratios and conduct a fundamental analysis.
Now that we understand the basics of a balance sheet let’s proceed to the next section to learn how it works.
How Exactly Does a Balance Sheet Work?
As explained above, a balance sheet provides an overview of the business’s financial position. The current balance sheet should be compared with those of previous periods to understand trends over a longer period. Investors can use different financial ratios, like the debt-equity ratio, to get a sense of the company’s financial well-being. The balance sheet follows a simple equation that equates assets with the sum of liabilities and shareholder equity.
Assets = Liabilities + Shareholders’ Equity
Let’s understand the balance sheet formula with an example – If a company takes out a five-year, $5,000 bank loan, its assets (cash) will increase by $5,000. The liabilities (long-term debt) will also increase by $5,000, thus balancing the two sides of the equation.
Thus, the logic behind how a balance sheet works is simple: a company has to pay for all the things it owns by either borrowing money or taking it from its investors.
Now, let’s understand the key elements of a balance sheet in the next section.
Key Elements and Components of a Balance Sheet
A balance sheet comprises various components and elements. It is essential to know what these components are and what they include to understand a balance sheet better. Below, we have mentioned the list of components in a balance sheet –
Assets
An asset is something that the business owns and is beneficial for its growth. Assets can be classified based on the following characteristics –
Convertibility
Convertibility determines how easily the asset can be converted into cash. Based on the convertibility, assets are further classified into two parts – current and non-current assets.
- Current assets can be easily converted into cash or cash equivalents within one year. Some examples of current assets include short-term deposits, marketable securities, and inventory.
- Fixed assets, on the other hand, cannot be easily or readily converted to cash. Some common examples of fixed assets are buildings, machinery, equipment, and trademarks.
Physical Existence
Depending on their physical existence, assets can be of two types – tangible and intangible.
- Tangible assets are assets that you can see and feel, like office supplies, machinery, furniture, and buildings.
- Intangible assets do not have a physical existence and include patents, brands, and copyrights. They are generally listed on the balance sheet only if they are acquired by the business rather than developed in-house.
Usage
Usage generally determines whether the asset is essential to conduct business operations. Based on their usage, assets can be classified into two parts – operating and non-operating.
- Operating assets are needed to conduct daily business operations and include buildings, machinery, and equipment.
- Non-operating assets are short-term investments or marketable securities that are not necessary for daily business operations.
Liabilities
A liability is any money that the company owes to other parties, including debts and other financial obligations that arise out of business transactions. A business settles the liabilities by paying them back in cash or providing an equivalent service to the said party. Liabilities are listed on the right side of the balance sheet, and depending on context, can be classified as current and non-current.
1. Current liabilities are debts or obligations that have to be fulfilled within a year. These are also called short-term assets and include accounts payable, interest payable, wages payable, short-term loans, etc.
2. Non-current liabilities are debts or obligations for which the due date is more than a year. These are also called long-term liabilities, and include bonds payable, long-term notes payable, pension fund liability, and deferred tax liabilities.
Owner’s Equity/ Earnings
Owner’s equity is calculated by reducing total liability from total assets. In simple words, owner’s equity is the amount that can be handed over to shareholders after paying off the debts and liquidating the assets. It is one of the most common ways to represent the net value of the business. An important part of shareholder’s equity is retained earnings. It consists of the net earnings a company either reinvests in the business or uses to pay off debt. The remaining amount is distributed in the form of dividends to the shareholders.
The equity value can be positive or negative, and a positive value means the company has enough assets to pay off its liabilities.
Why is a Balance Sheet Important?
There are many reasons why a balance sheet is an integral part of a company’s financial statement. By reviewing the balance sheet, various ratios can be determined that help understand the following about a business –
- Liquidity—Comparing a company’s current assets to its current liabilities helps understand its liquidity position. When current assets are greater than current liabilities, the company can cover its short-term obligations. Current and quick ratios are examples of ratios that help determine liquidity.
- Leverage – Understanding how a company is financed indicates how much leverage it has, which in turn indicates how much financial risk it is taking. By comparing debt to equity and debt to total capital, businesses and stakeholders can assess leverage through the balance sheet.
- Efficiency—By reviewing the income statement in conjunction with the balance sheet, it’s possible to assess how efficiently a business uses its assets. For instance, dividing revenue by the average total assets gives the asset turnover ratio, which indicates how efficiently the company turns assets into revenue. Moreover, the working capital cycle depicts how well a company manages its cash in the short run.
- Cash Flow – Changes in balance sheet accounts are used to calculate cash flow in the cash flow statement. For instance, an increase in plant, property, and equipment equals capital expenditure minus depreciation expense. If depreciation is known, capital expenditure can be calculated and included as a cash outflow, which comes under cash flow from investing in the cash flow statement.
- Rates of Return – A balance sheet can be used to evaluate business returns. For example, dividing net income by shareholders’ equity produces a return on equity (ROE), dividing net income by total assets produces a return on assets (ROA), and dividing net income by debt plus equity gives a return on invested capital (ROIC).
Thus, using the balance sheet, various ratios can help determine multiple aspects of a business’s financial position. However, there are still limitations to a balance sheet, as explained below.
What are the Limitations of a Balance Sheet?
Although the balance sheet is invaluable for investors and analysts, it has some limitations. Because it is static, many financial ratios draw on data included in the balance sheet, income statement, and cash flow statement to depict a fuller picture of a business’s financial health. For this reason, a balance alone may not give a complete picture of a company’s financial health.
Additionally, a balance sheet is limited due to its narrow scope of timing, as it only captures the financial position of a company on a specific day. Going through a single balance sheet by itself may make it difficult to determine whether a company is performing well. For example, a company reports $500,000 of cash in hand at the end of a particular month. Without context, a comparative point, knowledge of its previous cash balance, and knowing the industry operating situations, determining how much cash on hand a company has provides limited value.
On the other hand, different accounting systems have different ways of calculating depreciation and inventories. This also changes the figures posted to a balance sheet. Because of different calculation methods, businesses have some ability to manipulate the numbers and make them more favorable. Thus, you need to pay attention to the balance sheet’s footnotes to determine which systems are used in their accounting.
Lastly, a balance sheet is subject to several areas of professional judgment and estimates that materially impact the report. For instance, accounts receivable must be continually assessed for impairment and adjusted to reflect potential uncollectible amounts. In such a case, sometimes, a company must make estimates and reflect its best guess as part of the balance sheet without knowing which receivables it is likely to receive.
Hence, you must be careful about these limitations and assess the balance sheet accordingly.
Conclusion
We hope this blog helped you understand a balance sheet in detail. However, if you still have questions about a balance sheet or are facing problems while creating one, you can contact our team of experts at 1-855-546-5024, and they will help you resolve the issues.
FAQs
Who prepares a balance sheet?
Depending on the nature of the business, different parties may be responsible for preparing the balance sheet. For small businesses, the balance sheet might be prepared by the owner or a bookkeeper. For mid-size firms, the statement might be prepared internally and reviewed by an external accountant.
Public companies must obtain external audits by public accountants and ensure that their books, including balance sheets, are kept to a much higher standard. Their balance sheets and other financial statements are to be prepared as per the Generally Accepted Accounting Principles (GAAP) and filed regularly with the Security and Exchange Commission (SEC).
What are the reasons behind an unbalanced balance sheet?
There can be many reasons why your balance sheet is unbalanced, including the following :-
The data might be damaged or misplaced, which can cause discrepancies in reports.
The transactions are incorrectly entered, like a wrong amount or the item being on the wrong side.
You might be dealing in different currencies, and the fluctuation in exchange rates can lead to an incorrect balance sheet.
Inventory changes affect the cash flow statement and, in turn, the balance sheet.
The equity calculations might be incorrect, and it does not reflect the difference between assets and liabilities.
How can you avoid common balance sheet mistakes?
Here are some tips to help you avoid some common balance sheet mistakes:-
To avoid misclassification of items, follow the accounting standards and definitions for each item and review the nature and terms of each transaction carefully. Also, make sure to use consistent classifications across different periods and entities.
To avoid miscalculating the amount, use reliable software and tools and check the amount for accuracy and consistency. Remember to reconcile the balance sheet with the other financial statements and the source documents.
Follow the accounting standards and formats for presenting the balance sheet, and ensure that the items are clearly labeled and classified to avoid incorrect representation.
To avoid the omission of items, identify and record all the relevant items that affect the financial position and performance of the company and disclose them in the notes to the financial statements.
Lastly, establish and implement a sound internal control system that covers the policies, procedures, and controls for the balance sheet process. You must also monitor and evaluate the effectiveness and compliance of the internet control system.