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A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements. If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyze it and how to read it. (To learn more about reading financial statements, see What You Need To Know About Financial Statements, What Is A Cash Flow Statement? and Understanding The Income Statement.)
How the Balance Sheet Works
The balance sheet is divided into two parts that, based on the following equation, must equal (or balance out) each other. The main formula behind balance sheets is:
| assets = liabilities + shareholders' equity |
This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings.
Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.
It is important to note, that a balance sheet is a snapshot of the company’s financial position at a single point in time.
Know the Types of Assets
- Current Assets
Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes are: cash and cash equivalents, accounts receivable and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks. Cash equivalents are very safe assets that can be are readily converted into cash such as U.S. Treasuries. Accounts receivable consists of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit, which then are held in this account until they are paid off by the clients. Lastly, inventory represents the raw materials, work-in-progress goods and the company’s finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailers inventory typically consists of goods purchased from manufacturers and wholesalers.
- Non-Current Assets
Non-current assets, are those assets that are not turned into cash easily, expected to be turned into cash within a year and/or have a life-span of over a year. They can refer to tangible assets such as machinery, computers, buildings and land. Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated.
Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.
Learn the Different Liabilities
On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet. Current liabilities are the company’s liabilities which will come due, or must be paid, within one year. This is comprised of both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.
Shareholders' Equity
Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder’s equity account. This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.
Read the Balance Sheet
Below is an example of a balance sheet:
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| Source: http://www.edgar-online.com |
As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and the right side contains the company’s liabilities and shareholders’ equity. It also can be seen that this balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders’ equity.
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