What is a balance sheet?
A balance sheet provides a snapshot of a company’s assets, liabilities, and shareholder equity at a specific point in time.
Unlike other financial statements that report changes in financial activity over a certain period, balance sheets offer a glimpse of the current financial situation of an organization at a single point in time.
Exploring the Balance Sheet
The balance sheet conforms to the basic accounting equation. That is to say, the assets on one side equal the liabilities and shareholder equity on the other.
This equation, pictured below, is the foundation upon which modern double-entry bookkeeping is built. In short, for each transaction, the total debits equal the total credits.
The reasoning that goes into the accounting equation is hardly a stretch; a company has to pay for its assets (things it owns) by either taking on liabilities or using shareholder equity—borrowing the money or taking it from investors.
The balance sheet starts off with assets listed in order of descending liquidity. As a reminder, liquidity is the measure of how easily and quickly an asset can be converted into cash. This means that balance sheets start with cash as the top-line asset. From there they move on in a sequence of assets that are progressively less liquid:
- Accounts receivable
- Prepaid expenses
Accounts receivable includes money that the company is owed from customers. Inventory represents goods available for sale (but that have not yet been sold). Prepaid expenses represent value that has already been bought and paid for, such as insurance or rent.
The assets on a balance sheet don’t just include current-term assets like those listed above. They also include long-term assets such as the following:
- Long-term investments
- Fixed assets
- Intangible assets
Long-term investments represent securities that cannot (or will not) be liquidated in the next year. Fixed assets generally include land, machinery, equipment, buildings, and other durable assets. Intangible assets include things that are non-physical but still valuable.
For many companies this is restricted to intellectual property, though the category can be expanded to include such intangibles as corporate goodwill or brand association.
As one might expect, intangible assets are the hardest to value and would also be the hardest to sell and convert into cash. As the least liquid asset class, they are listed last in the asset portion of the balance sheet.
As with assets, the liabilities listed on a balance sheet include both current and long-term liabilities. Liabilities are the money that a company owes to others. Current liabilities are those that are due within a year and generally consist of the following:
- Wages payable
- Customer prepayments
- Interest or payments owed on debt
Long-term liabilities may include long-term debt (debt that will not be paid off inside of a year), bonds, deferred tax liability, and pension fund liability or other benefit payments.
Shareholder equity represents the company’s claim to assets once liabilities have been paid. If a company is publicly owned, dividends will be paid out of shareholder equity. These payments would be recorded on this portion of the balance sheet; the remainder, once any cash or stock dividends have been paid, is known as retained earnings (RE).
Limitations of Balance Sheets
Balance sheets are helpful tools for investors and decision makers alike. They do not, however, present the entire picture. Because a balance sheet is a snapshot in time, it presents just one aspect of a company’s finances. This static view cannot paint a full picture of finances or performance over time.
For this reason, balance sheets are almost never presented alone but are usually accompanied by income statements and cash flow statements to produce a full picture of where a company stands financially.