What is Balance Sheet ?
A balance sheet (also called the statement of financial position), can be defined as a statement of a firm’s assets, liabilities and net worth. It provides a snapshot of a business at a point in time. These are prepared at the end of an accounting period like a month, quarter or year end. Comparison of balance sheets over years helps to gauge the financial health of a business. It got its name as assets minus liabilities (net assets) must equal the owner’s equity (they must balance). Every business will generally need a balance sheet while applying for loans or grants, submitting taxes or seeking potential investors.
Balance sheet is based on the formula: Assets = liabilities + Net worth
Components of the Balance Sheet
The three major components of the balance-sheet that indicate what the company owns and owes are Assets, Liabilities and Owner’s Equity.
Assets can be defined as the valuables that the company owns to benefit from or are used to generate income. They are the resources of the company that have future economic value. These are categorized into tangible and intangible assets. The tangible assets are further bifurcated into current, long term and other assets. The non tangible assets are trademark, copyrights, goodwill to mention a few.
Current assets include the cash, accounts receivable, prepaid expenses and all that can be converted into cash within a year.
Long term assets are also called fixed assets. They are distinguished from the current assets due to their longevity in generating revenues. All fixed assets except for land are shown on the balance-sheet at original cost less depreciation.
Liabilities are debts owed by the business. These are claims of the creditors against the assets of the business. These are claims or obligations that arise out of past or current transactions. Liabilities are classified into current and long term liabilities.
Current liabilities are accounts payable, accrued expenses, taxes payable, the current due within one year portion of long term debt and any other obligations due within a year.
Long term liabilities are debts that must be repaid by the business in more than one year from the date of the balance sheet.
Net worth (Owner’s Equity): Owner’s equity (called when it’s sole proprietorship) sometimes is also referred to as the book value of the company because owner’s equity is equal to the reported asset minus the reported liability.
Assets = liabilities + Net worth, this can be reposed to yield the definition of net worth, which is the balance after the liabilities are subtracted from the assets of the business.
This section of the balance sheet includes:
- Paid up capital
- Retained earnings
- Treasury stock
Preparing a Balance Sheet
The two most common formats of reporting the balance sheet are the vertical balance sheet (where all line items are presented down the left side of the page) and the horizontal balance sheet (where asset line items are listed down the first column and liabilities and equity line items are listed in a later column). The vertical format is easier to use when information is being presented for multiple periods.
Example of Balance Sheet
What can be analysed from a Balance Sheet?
- The general financial state of the business at a specific point in time
- The amount of capital retained in the business
- The productivity, growth and solvency of the business
- The pace at which the assets can be converted to capital
Advantages of reporting the balance sheet
- Business snapshot:
Balance Sheet provides an accurate picture of the business status. While the profit and loss statement provides the profit made in a transaction, balance sheet gives the details of the bills the business owes to the vendors. Every balance sheet is unique; while a business may experience a high profit account, it can simultaneously have a poor balance sheet if the total net asset value is low and vice versa. Balance sheet determines the financial strength of a business and helps in future financial planning.
- Provides information for apt decision making:
Balance-Sheet provides the investors and potential lenders with the information needed to take decisions while lending money or resources. It reflects the company’s ability to collect and pay debts on time. On the basis of this, one can form an opinion of the company’s risk and return prospects.
- Provides helpful financial ratios:
Balance Sheet helps to calculate the ratios to determine a company’s long-term profitability and short-term financial outlook. Ratios like the current ratio and the acid test or liquidity ratio are calculated using information from the balance sheet. These ratios help obtain a very thorough summary of the company’s financial health by analyzing its cash position, working capital, liquidity and leverage. It also provides insight into the company’s likelihood of defaulting on its credit obligations or even its bankruptcy risk.
Disadvantages of the balance sheet
- Numbers could be misleading:
As the balance-sheet gives the financial snapshot at a given point of time, it could be misleading sometimes. For e.g. the analysis could get distorted if the company’s cash position at year end is high, indicating high reserves, but the company may intend to distribute it in the form of dividends.
- Doesn’t give true value of assets:
The balance sheet does not provide the true value of the assets as they are reported at the historical costs. It does not reflect the current market valuation.
- Other limitations:
The balance sheet has some of the current assets valued on estimated basis, so it does not reflect the true financial position of the business. Also there is complete omission of the valuable non monetary assets from the balance-sheet.
Balance-sheet is one of the essential financial statements needed to take appropriate and sound financial decisions. Blended with the other components (Profit and Loss Statement, Cash Flow Statement and Statement of Owner’s Equity) of financial reporting, one can decide whether the business under focus is right as an investment option.