A balance sheet is a type of financial statement. It gives you an overview of a company's financial status at a specific point in time, including what it owns, what it owes, and how much shareholders have invested in the business.
At a high level, the equation used for a balance sheet is quite simple. It is a sum of all the assets a company owns compared to the sum of all the company's debts and obligations to shareholders.
Business owners often use balance sheets to get a quick view of how well their business is doing at any given time. These reports are also used by investors and lenders to evaluate the company's creditworthiness, its ability to pay its bills, and its performance over time.
Let's learn more about how balance sheets work and what your business can use them for.
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How does a balance sheet work?
A balance sheet shows what resources a company has available at the moment (or during a particular time period), taking into account what it owes and who else has a right to the company's assets. Because balance sheets show a company's assets compared to its liabilities and equity, they give you a much better idea of the company's financial health than if you look at just the assets or liabilities.
Assets on a balance sheet are typically listed in order of liquidity, with the most easily accessible assets (such as cash) at the top, followed by less liquid options, such as:
- Real estate.
- Machinery.
- Electronic equipment.
- Products inventory.
Liabilities are organized according to the length of the term. The shortest-term liabilities will be at the top, as their financial impact will be the most immediate. A simple version of the balance sheet formula is assets = liabilities + stockholders' equity.
Balance sheets must comply with generally accepted accounting principles (GAAP) and are part of a holistic system of financial best practices, along with other financial reports and a complete chart of accounts.
Importance of a balance
Balance sheets are important because they indicate how healthy (or unhealthy) a company's overall finances are. This is especially true compared to the company's previous balance sheets.
If a company's assets are greater than its liabilities, it means that the company has positive shareholders' equity and net assets. Basically, that means that the company can pay its bills and is not willing to sink into its financial obligations. If the company maintains the positive balance for longer periods of time, it is a sign that the business will also perform well in the future.
On the other hand, if a company's liabilities are greater than its assets, then the company has negative shareholders' equity. That's a bad sign, and that kind of balance sheet indicates potential financial difficulties. The company could be at risk of defaulting on its debt.
If you see a decrease in stockholders' equity on several consecutive balance sheets over a period of time, then the company probably has serious financial difficulties on the horizon.
Components of a balance sheet
All balance sheets include three basic components: assets, liabilities and stockholders' equity.
Assets
Assets represent anything that the company believes could generate revenue or profits in the future. Companies expect assets to provide a return on investment (ROI) and contribute to the bottom line.
There are many different types of asset classes, but they include current assets and long-term assets.
Examples of current assets:
- Cash.
- Products inventory.
- Accounts receivable.
Examples of long-term assets:
- Real estate or properties.
- Equipment, including electronics.
- Investments.
Because balance sheets list assets in order of liquidity, longer-term assets will be shown at the bottom.
Passive
A liability is any type of financial obligation that a company has in its past. That includes accounts payable, taxes owed, bonds payable and other long-term loans.
Because something like bills owed will have a more immediate due date than a long-term loan, balance sheets list liabilities in order of when they must be paid. Liabilities with longer maturity dates will be at the end.
Shareholders' equity
Stockholders' equity is also known as “net worth.” As the name suggests, shareholders' equity is the amount of money that would have to be returned to investors or shareholders if a company failed and had to liquidate all its assets and quickly pay all its debts. Stockholders' equity also includes any profits that the company has retained from profits made over time.
The formula for calculating stockholders' equity is simply total assets minus total liabilities.
Balance sheet example
Here is a simple version of a balance sheet for a hypothetical company:
| Asset type | Amount |
|---|---|
| Current assets | $200,000 |
| Long-term assets | $150,000 |
| Total assets | $350,000 |
| Liabilities and equity | Amount |
|---|---|
| Current debt | $30,000 |
| long term debt | $100,000 |
| common actions | $150,000 |
| Retained earnings | $45,000 |
| Total liabilities and stockholders' equity | $325,000 |
A detailed balance sheet will list more detailed assets and liabilities. But notice that, for this hypothetical business, its total assets are greater than its total liabilities and shareholders' equity. That's a good sign.
Many types of software can make it easy to generate detailed balance sheets, including payroll software, accounting software, and even mobile accounting apps.
Uses of a balance sheet
A balance sheet is useful to a company's internal owners, managers, and employees, as well as outside investors and lenders. Balance sheets may represent only a snapshot of financial information, but they have several different valuable uses.
Evaluate the financial strength and viability of the business.
Metrics such as liquidity, solvency, financial flexibility and capital structure determine the overall financial health of a company. If a balance sheet shows few liquid assets and a list of liabilities with very little financial flexibility, then it is a sign that the business is not in good shape.
Alternatively, comparing balance sheets over time can identify positive trends, such as greater solvency and liquidity than the company had six months ago.
Evaluate the effectiveness of business management
If a company is run by a board of directors, then the balance sheet gives them and other investors information about how well the management team is running things.
Are managers using their resources effectively? Are they generating returns? If the existing management team is growing the company's assets and increasing equity, then it is a good sign to senior stakeholders that the day-to-day leaders are doing a good job.
Provide information to potential investors and lenders.
Balance sheets help investors and other types of lenders decide whether a company is a good investment or not. Since a balance sheet highlights information about the likelihood that a company can pay its debts, it can help investors decide whether or not they want to risk their capital.
Help with business valuation analysis.
If you want to know how much your company is worth, a balance sheet is one step in finding out. Balance sheet valuation models can help estimate the overall value of the company, including its book value, liquidation value, and potential return on assets and equity.
Identify how much working capital the company needs.
Since a balance sheet lists different asset and liability accounts together, it can be easier to determine how much short-term cash flow a business needs to continue operating. That is valuable information for decision makers.
Business stakeholders, both inside and outside the company, can use balance sheets to evaluate a company's financial position, performance, flexibility, risk and quality of management for long-term and long-term decision making. short term.
