Any accountant and aspiring accountant would know that balance is very important in accounting.
Hence, why one of the financial statements (two if you count the trial balance) prepared by accountants is named the balance sheet
Okay, that may be kind of a stretch, but no one can deny that balance is important in accounting.
Also, the balance sheet is one of the three main financial statements prepared by accountants, the other two being the income statement, and the cash flow statement.
The Balance Sheet: What is it?
Also known as the statement of financial position, the balance sheet provides us with a general view of an individual’s or a company’s financial standing which includes its total assets, total liabilities, and total equity.
It is used by analysts to arrive at important financial ratios such as the rate of return, debt-to-equity ratio, etc.
While some balance sheets may show more detailed information, most balance sheets will provide you with just enough information to gauge a business’ total assets, how it is financed (debt, equity, or a mix of both), and whether it is doing well in regards to its financial standing.
The information should be enough to answer questions like:
- How much cash do we have?
- Do we still have some accounts receivable that we can collect?
- How much debt do we owe?
The Assets=Liabilities+Equity Formula
Most balance sheets follow the formula: Asset = Liabilities + Shareholders’ Equity.
This equation provides us with three broad categories, them being Assets, Liabilities, and Equity.
It is arranged in such a way so that whenever there is a change in our total assets, we can readily attribute it to a change in our liabilities or equity.
Say for example, for the year 20XX, we decided to take out a cash loan of $7,000 from a bank.
This transaction will reflect an increase in our total assets, which can then be attributed to an increase in our liabilities (the journal entry should be like ‘debit: cash’, ‘credit: loans payable’).
Another example, one of our investors decided to donate a building which is valued at $100,000 to the company.
This transaction will reflect an increase in our total assets, which can then be attributed to an increase in our equity (the journal entry should be like ‘debit: building’, ‘credit: donated capital’).
As illustrated, the Assets = Liabilities + Equity Formula can easily tell us whether an increase or decrease in our assets is caused by a change in our liabilities or equity.
Just remember that an asset has to be paid/accounted for by either borrowing from a creditor (liability) or by taking it from our investors (equity).
The Contents of a Balance Sheet
As mentioned previously, the balance sheet contains information that will give you a general view of an individual’s or a company’s financial standing.
It is to be noted though that this information is only relevant for a specific moment in time.
For example, if the balance sheet states ‘for the year ended December 31, 2020’, it will only include information regarding that year, and not the previous years or any upcoming years.
That’s why a balance sheet by itself won’t exactly give you a history of the company’s trends and performances unless you compare it with previous period balance sheets.
Some companies prepare financial statements for the current year, along with the previous year’s.
Here's a sample:
The balance sheet can also be used to arrive at significant financial ratios which can give us an idea of how financially healthy a business is.
Some of these ratios are the working capital ratio which represents a company’s ability to pay its current liabilities with its current asset, the debt-to-equity ratio which gives us an idea of how the company is financed (is it debt-heavy? Is it equity-heavy?), and many more.
The Assets=Liabilities+Equity Formula provides us with three broad categories: Assets, Liabilities, and Equity.
We will expand on these three categories next.
Assets
Simply put, assets are properties (be it tangible or intangible) that a company owns or controls.
Accounts under this category are listed in terms of liquidity, meaning that the most liquid asset goes on top, while the least goes at the bottom.
This is why in most balance sheets, you see cash as the first item listed.
Cash is the most liquid asset after all.
The assets category can then be further categorized into two categories: current assets and non-current assets.
Current assets are assets that can be readily converted to cash in a year or less (e.g. cash, inventory, accounts receivable), while non-current assets refer to those that cannot be readily converted to cash (e,g. long-term investments, machinery, building).
Assets are usually listed in this order:
Current assets
- Cash and cash equivalents – being the most liquid assets, this is usually the first to be listed. This account can also include treasury bills and short-term certificates of deposits.
- Marketable securities – these are equity or debt securities that have a liquid market (e.g. stocks of another company, bonds, futures, options)
- Accounts receivable – this refers to cash owed by customers of the company, usually related to services or products offered by the company; an allowance for doubtful accounts is usually paired with this account
- Inventory – refers to goods that the company offers; do note that manufacturing companies have accounts such as raw materials inventory, work-in-process inventory, and finished goods inventory
- Prepaid expenses – refers to expenses that have already been paid for, such as prepaid rent, annual insurance, etc.
Non-current assets
- Long-term investments – these are securities that cannot be readily converted to cash in the current year or even the next year; an example of this would be held-to-maturity securities
- Fixed assets – these are tangible properties that have a long life (e.g. land, machinery, equipment, buildings); a corresponding accumulated depreciation account is paired with this account
- Intangible assets – these are properties that don’t have a physical form (e.g. software, goodwill). Intangible assets are usually only listed if they are acquired
Liabilities
Liabilities are what the company owes to outer parties such as creditors, or sometimes customers (in the case of unearned revenue).
Examples of liabilities are loans, unpaid bills such as rent and utilities, and unpaid interest.
Such as with assets, the liabilities category can be further categorized into two categories: current liabilities and non-current liabilities.
Current liabilities are those that should be paid within a year such as unpaid rent.
In contrast, non-current liabilities are those that are not due within a year such as long-term loans payable.
Do note that a long-term loan may have a current component on it.
To illustrate this, imagine your company decided to loan from bank XX the amount of $5,000, with a term of five years.
Annual payments of $1,000 plus interest must be made to settle this debt.
In this case, we can categorize the annual payment due for this year (which is $1,000) as a current liability, while the balance can be categorized as a non-current liability.
The current liabilities account can include the following:
- Current portion of long-term debt (as illustrated above)
- Bank indebtedness – usually refers to an agreement with a bank to have a credit line or a revolving credit facility; similar to a credit card
- Accrued expenses – are expenses that have already been incurred but not yet paid; can include utilities, rent, etc.
- Interest payable – refers to interest on current liabilities
- Unearned revenue – prepayments made by customers for goods or services that they expect to receive
- Dividends payable – refers to dividends payable to investors
- Accounts payable – refers to money owed to supplier for goods or services that the company has received
Non-current liabilities may include the following:
- Long-term debt – for debts that have a term of more than one year
- Pension fund liability – refers to the amount of money a company has to pay for its employees’ retirement accounts
- Deferred tax liability – accrued taxed but is not payable for another year (usually the result of a timing difference, or as reconciliation for financial reporting and tax assessment
- There may be some liabilities that don’t appear on the balance sheet, but this is more of an exception rather than the rule. For cases like this, information might be supplemented in the notes to the financial statements.
Equity (Shareholders' Equity)
Also referred to as ‘net assets’, shareholder’s equity or equity refers to money or properties attributable to the owners (e.g. company = shareholders, partnership = partners, sole proprietorship = proprietor).
It is referred to as ‘net assets’ because it is the figure that you’d come up with after you deduct the total liabilities from your total assets.
This category often includes the accounts common stocks, and retained earnings, but can also include preferred stock, treasury stock, donated capital, etc.
The common stock account refers to the shares issued by the company to its investors.
It is usually reported at par value, and at most times listed with additional information regarding the authorized shares and issued shares.
Preferred stock is another kind of share that is different from the common stock and is listed separately.
Not all companies issue this kind of stock though.
It usually doesn’t have the voting power that common stock has, but it can come with different perks.
The treasury stock account refers to stocks/shares repurchased by a company.
There can be several factors as to why a company would want to repurchase outstanding stocks such as improving financial ratios, controlling interest to avoid a hostile takeover or retirement of stocks, etc.
Retained earnings are the net earnings (if there are any) that a company retains, either to appreciate capital by reinvesting in profitable ventures or properties, or reserved as payment for debts.
Can be further categorized as “restricted retained earnings” and “unrestricted retained earnings”.
Restricted retained earnings refer to a portion of the retained earnings that is restricted to a specific purpose (e.g. land expansion, building acquisition, etc.) and cannot be used for anything else.
This should be backed up by a board resolution. Unrestricted retained earnings refer to the amount that can be used for whatever purpose.
Oftentimes, the purchase price and the book value of a stock are not the same.
That’s where additional paid-in capital comes in.
It is the amount that shareholders paid for over a stock’s book value.
As an example, let’s say company A issued 100 shares with a par value of $1 per share to investor X, to which the latter paid S1.50 per share.
The excess $0.50 per share or a total of $50 is then recorded as additional paid-in capital in the company’s books.
Limitations of the balance sheet
While the balance sheet is a very useful tool for assessing a company’s financial standing, it does have its limitations.
We’ve already mentioned before that it can only give you a general view of a company’s financial standing at a specific point in time.
On its own, it does not show you how a company operates, or how profitable a company really is.
An increase in assets does not always equate to a profit after all.
It may have been because of an increase in liabilities.
It also does not show you the cash flow, such as how it is used, or where it came from.
It only shows you the balance at a specific point in time.
That is why it should be used in conjunction with the income statement and cash flow statement.
These three together will certainly provide you with a better view of a company’s financial standing.
Make sure that there are proper controls in preparing your balance sheet.
Management may be able to cheat the system and show you a more positive balance sheet than it should be.
They may be able to understate the allowance for doubtful accounts which in turn results in overstated net accounts receivable, or they may play with how depreciation is accounted.
At the end of the day, the balance sheet on its own is not enough to fully gauge a company’s financial well-being.
Even the information it presents can be limited which is why most companies prepare accompanying notes to their financial statements.
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