Balance Sheet - Explained
What is a Balance Sheet?
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Table of ContentsWhat is the Balance Sheet?How is a Balance Sheet Used?What Does the Balance Sheet Tell You?AssetsCurrent AssetsNon-current Assets (Long-term Assets)LiabilitiesCurrent LiabilitiesLong-term LiabilitiesShareholders' EquityLimitations of Balance SheetsAcademic Research on Balance Sheet
What is the Balance Sheet?
A balance sheet is a report or statement containing all the assets, liabilities and shareholders' equity owned by a business at a specific time. Balance sheet is important in financial accounting, it is the financial statement that contains the details of a company's asset, equity and liabilities over a period of time time. This statement is also helpful in gaining insights to the capital structure of a business. Business, whether corporations, private limited company, sole proprietorship or business partnership must have balance sheets. This financial statement reveals the income and expenditure is the business of what the business owns and owes over a period of time.
Back to: ACCOUNTING, TAX, & REPORTING
How is a Balance Sheet Used?
Typically, a balance sheet follows this pattern; Assets = Liabilities + Shareholders Equity The balance sheet reveals the assets owned by a company and liabilities owed by the same company. Assets, liabilities and shareholders equity are crucial in the finance of every company and this is why they are reported in the balance sheet. A balance sheet is also the statement of financial position of a company and it is used alongside other statements to carry out a financial analysis of the business.
What Does the Balance Sheet Tell You?
A balance sheet is simply a highlight of the financial condition of a company at a specific time. It is the financial statement that reflects the company's finances, the assets owned, liabilities owed and the amount of shareholders equity. A balance sheet only reports a specific period, it could be a year. Hence, to determine the financial trends in a company over an elongated period, previous balance sheets must come into the picture. Also, the balance sheet of a company could be compared to that of other companies in the same industry to gauge the financial performance and health of the company. Investors who seek have a snapshot into how financially healthy a company is, can do so through the balance sheet. Here are some important things to note about a balance sheet;
- A balance sheet reports the assets, liabilities and shareholders equity of a business for a specific period.
- The balance sheet alongside the income statement and statement of cash flows are the three financial statements needed for the evaluation of a business.
- A company's balance sheet reveals what the company owns and owes.
- Through the balance sheet, how healthy a business is can be determined.
- The balance sheet is an important element in the calculation of financial ratios.
There are two broad categories of assets, these are current assets and non-current assets. Current assets can be converted into cash in a year or less than year. Non-current assets cannot be converted into cash within a short period of time, they are long-term assets. Below is a breakdown of accounts under current assets and those under non-current assets.
- Cash and cash equivalents (hard currency, treasury bills and others.)
- Inventory (goods available for sale)
- Prepaid expenses such as rent and insurance.
- Marketable securities.
- Accounts receivable (cash that customers owe the company.)
Non-current Assets (Long-term Assets)
- Fixed assets such as machinery, land and buildings.
- Intangible assets (trademark, goodwill and intellectual property).
- Long-term investments.
Liabilities in a company's balance sheet comprises of the money it owes to outsiders such as money to be paid to vendors and suppliers, salaries, rent, utilities and money it owes creditors. There are two categories of liabilities, these are;
- Current liabilities, and
- Long-term liabilities.
While current liabilities are those due within a year, long-term liabilities have longer life span. Below are examples of accounts under each category of liability.
- Dividends payable
- Bank debts
- Rent, tax, wages and utilities payable
- Interests payable
- Current portion of long-term liability, and
- Customers prepayments.
- Long-term debt
- Deferred tax liability
- Pension fund liability.
It is important to know that there are some liabilities that are not recorded on the balance sheet, they are called 'off the balance sheet liability.'
Shareholders' equity refers to the amount of money that belongs to the owners of the company. Shareholders of a company are investors who hold a significant amount of the company's ownership. They are sometimes referred to as the owners of the company due to the number of shares owned. The forms of shareholders' equity are;
- Retained earnings: the earnings of the company set aside to pay dividends to shareholders, settle debts and for reinvestment purposes.
- Preferred stock or common stock which can be converted to common shares are a later date.
- Treasury stock, stock reserved to foil hostile takeovers.
- Contributed capital or additional paid-in capital.
Limitations of Balance Sheets
Despite that the balance sheet is of importance to analysts and those who want to invest in a company, it has some limitations. Below are some of the limitations of a balance sheet;
- A balance sheet is not a dynamic financial statement, it is static.
- The figures contained in a balance sheet can easily be influenced by factors such as inventories, depreciation or amortization.
- Financial managers can manipulate a company's balance sheet to make out attractive to investors.
- There are multiple accounting systems used for balance sheet.
Also, a balance sheet only contains the financial condition or position of a company for a specific time, and not historical periods.