Understanding Balance Sheet In Detail
What Is Balance Sheet
One of the three fundamental financial statements, the balance sheet is essential to both financial modelling and accounting because it represents the total amount of assets and liabilities. The balance sheet shows the total assets of the company, as well as how those assets are financed, whether through debt or equity financing options. This financial statement is also known by the term statement of financial position.
The balance sheet is based on the fundamental equation: Assets = Liabilities + Equity.
Balance sheets, like all financial statements, will differ slightly from one organization or industry to the next, depending on the circumstances. But there are a few "buckets" and line items that are almost always included in common balance sheets, which are listed below. We will go over some of the most frequently encountered line items under Current Assets, Long-Term Assets, Current Liabilities, Long-Term Liabilities, and Equity in a brief fashion.
Rule Of Thumb
The assets on a balance sheet represent the things that the company has invested its money in (cars, machines, etc.), whereas the liabilities and equity represent the sources of the company's money (shareholders vs. debt).
Assets can be defined as valuables that a company owns in order to benefit from them or to use them to generate income for the company. They are the resources of the company that have the potential to generate future financial value. These are divided into two categories: tangible assets and intangible assets. The tangible assets are further subdivided into three categories: current assets, long-term assets, and other assets. To name a few examples of intangible assets, trademarks, copyrights, and goodwill are all available.
A current asset is a piece of property that meets the criteria for being an asset, but whose useful life is expected to be less than 12 months at the time of purchase.
The following general examples fall into the category of current assets.:
Cash or cash equivalents, which have no expiration date and have an unlimited useful life
Items kept for the purpose of trading
Item(s) that are consumed, sold, or expire within 12 months of purchase
Inventory is a good example of a currently held asset. A company purchases goods and raw materials in order to manufacture finished goods for sale. That means the inventory should be classified as current if, under normal circumstances, it is consumed during the normal operating cycle and should be classified as such.
Let's take a look at some of the current asset lines on the balance sheet to get a better sense of what the balance sheet is made up of.
Cash and Equivalents: Cash, the most liquid of all assets, appears on the balance sheet's first line as the most liquid asset. In addition, assets with short-term maturities of less than three months, as well as assets that can be liquidated on short notice, such as marketable securities, are grouped together under this line of accounting. In the footnotes to the balance sheet, companies will typically disclose which equivalents they have included in the balance sheet.
Accounts Receivable: This account contains the balance of all sales revenue that has not been charged to a customer's account, less any allowances for doubtful accounts (which generates a bad debt expense). As companies recover accounts receivable, this account decreases in value, and cash increases in value by the same amount as the account decreases in value.
Inventory: In the balance sheet position inventory, all raw materials and finished goods that are ready for sale or consumption are gathered together. When a company purchases oranges in order to make orange juice, the oranges become part of the company's inventory. Once the company has produced the juice and sold it to customers, the inventory position will be reduced by the value of the oranges that have been consumed by the company.
Prepaid Expenses: A prepaid expense is a current asset that is used to pay for a cost prior to the cost being invoiced. Let's pretend that the company was so pleased with the oranges from this season that it had already ordered and paid for oranges from the following season before the season ended. While the pre-purchase would result in a reduction in the cash position on the balance sheet, the prepaid expenses would result in an increase of the same amount. There would be no net change on the balance sheet as one asset declines while the other increases, effectively resulting in a zero net change.
An asset is classified as non-current if it is used by the company for a long period of time, i.e. more than 12 months. These assets can be both tangible and intangible, and they can be either operating or financial in nature:
Long-term financial investments
Property, plant & equipment
Brands, patents, goodwill
Examine some of the noncurrent assets on the balance sheet to see how they differ from current assets.
Plant, Property, and Equipment (PP&E): Assets such as property, plant, and equipment (also known as PP&E) represent the tangible fixed assets of a company. The line item is recorded after deducting the amount of accumulated depreciation. Some businesses will categorise their PP&E assets according to the different types of assets they have, such as land, buildings, and various kinds of equipment. Except for land, all property, plant, and equipment (PP&E) is depreciable.
Intangible Assets: This line item includes all of the company's intangible fixed assets, which may or may not be distinguishable from tangible fixed assets. Patents, licences, and proprietary formulas are examples of identifiable intangible assets. Brand and goodwill are examples of intangible assets that are difficult to quantify.
Financial Investments: Stocks, bonds, and minority stakes in other companies can all be used as long-term investments, as can mutual funds.
Other Assets: Any additional items that do not meet the requirements for current and non-current assets are included in the category of other assets. These can include, for example, long-term deferred assets that a company does not intend to use up within the company's normal operating cycle.
Generally speaking, a liability is an obligation that results in the transfer of a monetary benefit to another business or individual. For the uninitiated, a liability is any debt or other financial obligation.
Liabilities are the value left over after subtracting shareholders' equity from the total value of the company.
Like assets, liabilities can be classified as current and non-current
Current liabilities have a life of no more than 12 months, which is similar to the life of current assets. To be classified as current liabilities, items must meet a number of requirements, the most significant of which are as follows:
The settlement of the obligation occurs during the course of the business' normal operating cycle.
A settlement obligation must be satisfied within 12 months of the date of the preparation of the balance sheet and cannot be postponed beyond that time frame.
It is held for trading purposes
The following gives an overview of the main current debt items:
Accounts payable: Accounts payable refers to a short-term debt or obligation that a company owes to one or more of its suppliers. If the company in our previous example purchases its oranges on credit rather than in cash, the amount of accounts payable on the balance sheet increases as a result.
Accrued Liabilities: It is the balance sheet position of expenses that have been incurred but for which the invoice has not yet been received that is known as accrued liabilities As a rule of thumb, the accrued liability position is only an estimate of the costs, and the actual value will almost always differ from the estimated cost. A utility bill would serve as an illustration (gas, water, electricity). It is true that the company incurs costs over a period of time, but that the actual invoice will not be received until after the utility period has expired. Once the invoice has been received by the company, the accrued liability position will be converted into accounts payable until the invoice is paid.
Short-term Debt: Short-term debt refers to the portion of a debt that is due within twelve months of the date of the debt's creation. For example, a revolving credit facility that is used to fund short-term working capital requirements could be considered. A further possibility is that it is the maturing portion of long-term debt, which is labelled as "current portion of long-term debt."
Current Debt/Notes Payable: Non-accounting obligations that are due within one year or within one operating cycle for the company are included in this category (whichever is longest). In addition to the short-term version, notes payable may also be available in a long-term version with a maturity of more than one year.
Current Portion of Long-Term Debt: This account may or may not be lumped together with the above account, Current Debt. While they may seem similar, the current portion of long-term debt is specifically the portion due within this year of a piece of debt that has a maturity of more than one year. For example, if a company takes on a bank loan to be paid off in 5-years, this account will include the portion of that loan due in the next year.
If a company does not need to settle an obligation within the current operating cycle, it must classify the liability as non-current. These mainly include
long-term capital structure obligations,
financial obligations, as well as
contingent liabilities, where the obligation or magnitude is still uncertain.
Non-Current Borrowing: Non-current borrowing includes all items that concern the long-term capital structure of the company. For example, these include long-term loans and bonds issued that require repayment at some point in excess of 12 months.
Deferred Tax: A deferred tax liability exists due to the difference between tax and accounting methods. The classification as non-current requires the deferred tax liability to have a due date beyond 12 months.
Finance Lease Liabilities: If a company decides to lease a machine instead of buying it, the company has to activate the sum of the future lease payments on their balance sheet.
Retirement Obligations: Retirement obligations can include, for example, pension obligations to employees. These are entitlements of employees, depending on their years of service, that the company pays out once the employee retires.
Bonds Payable: This account includes the amortized amount of any bonds the company has issued.
Long-Term Debt: This account includes the total amount of long-term debt (excluding the current portion, if that account is present under current liabilities). This account is derived from the debt schedule, which outlines all of the company’s outstanding debt, the interest expense, and the principal repayment for every period.
Shareholder equity is the interest of the owners after subtracting the total liabilities from the total assets.
Equity = Assets – Liabilities
It represents the sum of the cumulative net results of all past transactions and events that affected the company since its foundation
Share Capital: The share capital of the balance sheet is the cash that a company received through selling ordinary and preferred stocks.
Retained Earnings: Retained earnings record the balance of all accumulated net earnings since the foundation of the business. In other words: The net income that a company generates every year – at least the part that is not distributed to the shareholders – will accumulate under “retained earnings” on the balance sheet.
If a company generates a positive net income, retained earnings and hence shareholders’ equity will increase (if not distributed). Vice versa, if the company incurs a net loss, retained earnings decrease.
Some jurisdictions additionally oblige companies to put aside a small part of their income instead of distributing the total net earnings to shareholders. However, this would be disclosed on a separate line item on the balance sheet.
Importance of the Balance Sheet
The balance sheet is a very important financial statement for many reasons. It can be looked at on its own and in conjunction with other statements like the income statement and cash flow statement to get a full picture of a company’s health.
Four important financial performance metrics include:
Liquidity – Comparing a company’s current assets to its current liabilities provides a picture of liquidity. Current assets should be greater than current liabilities, so the company can cover its short-term obligations. The Current Ratio and Quick Ratio are examples of liquidity financial metrics.
Leverage – Looking at how a company is financed indicates how much leverage it has, which in turn indicates how much financial risk the company is taking. Comparing debt to equity and debt to total capital are common ways of assessing leverage on the balance sheet.
Efficiency – By using the income statement in connection with the balance sheet, it’s possible to assess how efficiently a company uses its assets. For example, dividing revenue by the average total assets produces the Asset Turnover Ratio to indicate how efficiently the company turns assets into revenue. Additionally, the working capital cycle shows how well a company manages its cash in the short term.
Rates of Return – The balance sheet can be used to evaluate how well a company generates returns. For example, dividing net income by shareholders’ equity produces Return on Equity (ROE), and dividing net income by total assets produces Return on Assets (ROA), and dividing net income by debt plus equity results in Return on Invested Capital (ROIC).
Advantages of the balance sheet
The balance sheet provides an accurate picture of the current financial situation of the company. While the profit and loss statement shows how much money was made in a particular transaction, the balance sheet shows how much money the company owes to its vendors in that transaction. When a business experiences a high profit account, it can simultaneously have a poor balance sheet if the total net asset value is low, and vice versa. When a business experiences primarily a negative profit account, it can simultaneously be experiencing a positive profit account. Balance sheets are used to determine the financial strength of a company and to assist in financial planning for the long term.
The Balance-Sheet provides investors and potential lenders with the information they require in order to make informed decisions when lending money or resources to the company. This indicator shows how well the company performs in terms of collecting and paying debts on time. On the basis of this information, one can form an opinion about the risk and return prospects of the company.
The balance sheet is used to calculate the ratios that are used to determine the long-term profitability and short-term financial outlook of a company. The information from the balance sheet is used to calculate ratios such as the current ratio and the acid test or liquidity ratio, among others. These ratios assist in obtaining a very thorough summary of a company's financial health by analysing its cash position, working capital, liquidity, and leverage, among other factors. It also provides insight into the likelihood of the company defaulting on its credit obligations, as well as the possibility of going bankrupt.
Disadvantages of the balance sheet
It is possible that the balance-sheet, which represents the financial picture at a specific point in time, will be deceiving at times. Suppose the company's cash position at year end is high, implying that it has significant reserve funds. However, if the company intends to distribute this cash in the form of dividends, the analysis may be distorted as well.
The balance sheet does not reflect the true value of the assets because they are reported at their historical costs on the statement of financial position. It does not reflect the current market valuation at this point in time.
Because some of the current assets on the balance sheet are valued on an estimated basis, the balance sheet does not accurately reflect the true financial position of the company. Aside from that, the valuable non-monetary assets have been completely excluded from the balance-sheet calculation.
Among the most important financial statements required by a company to assess the performance and financial position of the organisation is the Balance Sheet. Every Accountant, as well as anyone interested in pursuing a career in accountancy, is expected to be familiar with the creation and analysis of a Balance Sheet, as well as other important financial statements.