A balance sheet is a type of financial statement that outlines a particular business's assets, liabilities, and shareholders' equity on a specific day. It's used to evaluate a company's financial health and is also known as a "statement of financial position." Businesses use various accounting tools — including a balance sheet — to assess where a company is financially at a specific point in time.
Balance sheets are not meant to show earnings the way that a profit and loss statement (P&L) does. Instead, balance sheets are meant to balance out, typically by following the accounting equation:
Assets = Liabilities + Shareholders' Equity
"I like to explain to clients that the profit and loss statement is a movie, while the balance sheet is a photo. The P&L reflects income and expenses over time, but the balance sheet shows the company's financial position within a single fixed moment," explains Courtney Barbee, owner and COO at The Bookkeeper.
So for example, a P&L statement may cover profits and expenses over Q4, while a balance sheet covers what the company owns and owes on the last day of Q4.
Components of a balance sheet
As mentioned above, there are three primary components of a balance sheet that are meant to balance out. Typically, companies use the equation: Assets = Liabilities + Shareholders' Equity, but you can also reorder this equation in other ways, e.g., Liabilities = Assets - Shareholders' Equity. The result should still be an equal balance on both sides of the equations, you're just reordering the calculations.
Here's what these components involve:
Assets
The first part of a balance sheet typically lists out the value of what a company owns.
"The top portion is the assets: items of value, tangible or intangible, that the company owns. These might include cash, accounts receivable, equipment, or even things like a trademark or prepaid expenses."
These assets are typically divided into current and non-current assets and listed in order of liquidity.
Current assets include cash and cash equivalents, accounts receivable, inventory., and anything else of value that can be expected to convert to cash within one year.
Non-current assets can include things like equipment, investments, copyrights, and intellectual property that have value but are generally long-term assets that are not expected to convert to cash within a year.
Liabilities
Below assets, a balance sheet then typically has a liabilities section. This includes money owed for debt or expenses. This also includes current and non-current liabilities, similar to the split between current and non-current assets.
Current liabilities can be things like accounts payable, accrued expenses, and debt obligations due within a year.
Non-current liabilities are longer-term expenses, like long-term bonds issued by the company and deferred tax liabilities, expected to be due more than a year from now.
Shareholders' equity
Shareholders' equity, also called owner's equity depending on the company structure, refers to the portion of a company's assets that the shareholders or owners of a company have claim to. This equity often includes components such as how much shareholders have invested in the company as well as the retained earnings, meaning profit that's kept by the company.
The shareholders' equity can also refer to the net assets, which is the total liabilities subtracted from total assets.
Reading a balance sheet
When it comes to balance sheet presentation, you can find either a vertical balance sheet such as the one pictured below where items are listed in a column that is read vertically, or up and down.
There's also the possibility of a horizontal presentation, where assets and liabilities and equity are side-by-side, read horizontally. In this case, on the right side you'll see liabilities listed as well as the shareholders' equity and on the left side, there are the assets listed. Vertical presentation tends to be more common.
"On the balance sheet, assets are listed in order of how readily convertible they are into cash. Liabilities are listed in order of how soon the requisite payment is due and payable," explains Phil Weiss, CFA, CPA and principal at Apprise Wealth Management.
"Beneath the assets are the liabilities, the things the companies owe. This isn't just debt such as loans or credit cards, but could also include unearned revenue," adds Barbee. "Paired with the liabilities is the shareholders' equity. All of the P&L statement, up until the date of the balance sheet, is actually housed in this portion as retained earnings."
The balance sheet equity line may include more than meets the eye and can be an important metric for investors to review.
"It also includes equity that has come in via things like cash infusions or stock sales, as well as equity which has left via distributions. The liabilities and shareholders' equity sum together to equal the assets, resulting in the balance sheet," explains Barbee.
Example of a balance sheet
As an investor, you can review important financial statements from publicly traded companies through the Securities and Exchange Commission (SEC). Here's an example of a balance sheet from Apple, on page 3.
As you can see, there are assets divided by current assets, including their subcategories, as well as non-current assets and their respective sub-categories. Below that, you can see current liabilities and non-current liabilities with their respective subcategories. At the bottom, you can review the shareholders' equity.
How is a balance sheet used?
Balance sheets can play an important role in assessing the financial health and performance of a company. Whether used at a large publicly traded company or a small business, balance sheets can reveal important information about what a company owns vs. what it owes.
More specifically, a balance sheet helps with:
Financial analysis
A balance sheet can be used to analyze a company's financial standing in several ways. For one, looking at its liabilities vs. assets can show whether the company is getting in over its head with debt. Digging deeper, looking at details like current assets vs. current liabilities, you can see if a company has solid liquidity to meet its short-term debt obligations. Similarly, you can assess long-term solvency by seeing if the company has the assets needed to cover long-term debt obligations.
Looking at shareholders' equity in relation to these other components also reveals key financial insights, like a company's ability to retain earnings and have a strong base of invested capital, which can suggest that the company might not need to rely on debt as much.
Ratio analysis
A balance sheet contains key data that can be used to calculate specific ratios that help with financial analysis. For example, when calculating a company's debt-to-equity ratio by dividing liabilities by shareholders' equity, a high number indicates that the company potentially has an unhealthy reliance on debt, whereas a low number suggests that it has a solid investment base.
The shareholder's equity portion of a balance sheet can also be used in conjunction with the earnings portion of an income statement. When dividing earnings by equity, you get a return on equity (ROE) number, with a high one suggesting that investors' capital is being put to good use to generate significant earnings, while a low one suggests that the investments aren't generating much profit.
Comparison and trend analysis
While balance sheets provide a snapshot of financial information, looking at balance sheets over time can indicate trends, like whether a company is getting a better handle on its debt. Comparing balance sheets among industry peers can also help when assessing one investment over another.
Pros and cons of using a balance sheet
A balance sheet is one of the key financial statements that businesses should use as part of evaluating their company finances. It's also possible for investors to review balance sheets of publicly traded companies to determine their profitability. It's important to understand the benefits of reviewing a balance sheet and understanding its limitations as well.
|
Pros |
Cons |
|
Provides a snapshot of liquidity |
An individual balance sheet doesn't show growth over time |
|
Understand overall leverage, when comparing liabilities to equity |
Is best used in conjunction with other financial statements, not on its own |
|
Offers insight into a company's financial health at a specific point in time |
Depreciation or the type of accounting method may shift values on the balance sheet, making it appear more profitable than others may calculate |
Importance of the balance sheet
Balance sheets can be important to many stakeholders, such as:
Investors
Investors can look at a company's assets and liabilities, as well as calculate metrics like ROE before deciding to invest in a particular company.
"Investors look at balance sheets to help assess a company's financial viability," says Weiss.
When assessing whether a company is appropriately valued, market value is typically analyzed side-by-side with book value. Book value is basically the value of a company according to its balance sheet.
To get a company's book value, you take the difference between a company's total assets and total liabilities. Market value is the company's market capitalization, meaning its share price x number of shares.
A stock is generally considered undervalued if its market value is well below its book value, since this indicates the stock is trading for less than what the company's net assets are worth. However, because balance sheets are snapshots, this isn't always true, as market values can reflect investors' future expectations.
For example, fast-growing companies often have higher market values than book values. This is because investors are optimistic about their potential for future revenue and overall valuation gains, and also because some companies have more earnings power, or ability to generate profit, than current assets. In some cases, however, a higher market than book value could, in fact, indicate that the asset is overvalued.
Creditors
A balance sheet is also useful to creditors who want to assess a company's ability to repay debts before making new loans. For example, if the company has limited liquidity, as evidenced by current assets essentially matching current liabilities, then a creditor might be hesitant to provide short-term debt. They might instead offer long-term debt at a higher interest rate, for example, or ask for collateral to reduce risk.
Management
A company's management team can also use balance sheets, not just for informing investors and creditors, but also to make more informed decisions about how they run the company. For example, a company that's considering making investments in new assets like new buildings or machinery might analyze its assets vs. liabilities to assess whether now is a good time to make those new investments.
Management can also assess areas like current liabilities to identify ways to cut short-term costs and free up cash flow now. Refinancing debt to a lower interest rate, for example, helps in this regard.
picture of a company's financial health than any individual financial statement."
FAQs about balance sheets
How often is a balance sheet prepared?
A balance sheet is often prepared quarterly or annually, but it depends on the company and the situation. For example, a small business applying for a loan may need to produce an updated balance sheet at that time.
What is the difference between a balance sheet and an income statement?
A balance sheet shows what a company owns and owes, and it provides a snapshot in time. In contrast, an income statement shows profit and loss over a given period, such as the previous quarter.
Where can I find a company's balance sheet?
Publicly traded companies generally publish their balance sheets in their quarterly and annual reports, which you can find on their websites or through SEC filings. Private companies might not make their balance sheets publicly available.
