There are three core financial statements used in business accounting: the income statement,statement of cash flows and the balance sheet, also referred to as the statement offinancial position. Creating and maintaining an accurate balance sheet is critical tounderstanding the company’s financial status and informing business leaders andinvestors.
What Is a Balance Sheet?
The balance sheet is one of your company’s most important financial statements. Itprovides asnapshot of the company’s financial position at a specific point in time. Managerialaccountants, business managers and investors use balance sheets as a key source ofinformation to better understand the company’s financial health.
Key Takeaways
- A company’s balance sheet is a snapshot of its financial position at a specificpoint intime.
- The balance sheet lists everything that the company owns (its assets), everything thatit owes (its liabilities), and shareholder equity.
- The difference between assets and liabilities is the equity in the company, whichbelongs to the owners. In a healthy company, this equity is a significant positivebalance; if it’s negative, the company is technically insolvent.
- The balance sheet doesn’t provide information about the company’s revenue orcash flow,so it needs to be analyzed together with other financial data to gain a full picture ofthe company’s financial health.
- The information in the balance sheet can be used to help assess the company’sliquidity,operating efficiency and potential return on investment.
What Is Included on a Balance Sheet?
A company’s balance sheet includes everything that the company owns and everything thatitowes—all of its assets and liabilities, in other words. It also shows the owners’ or shareholders’ equity in thecompany,which is equal to the difference between its assets and liabilities. For a privately-heldcompany, the shareholders typically include the founders and any investors. For a publiccompany, they include anyone who owns the company’s stock.
The balance sheet provides a snapshot of the company’s assets and liabilities on aspecificdate, such as the end of a fiscal quarter. Companies generally produce balance sheets atleast once a year, and often quarterly and/or monthly as well.
The balance sheet reflects the cumulative effect of all the company’s transactionssince theday the business started. For this reason, it is sometimes called the statement of financialposition. It provides insights into the business’s overall financial health,including:
- Whether the company’s assets exceed its liabilities.
- How much money is currently invested in the business.
- Any profits retained in the business.
- How much debt the company carries, and how much of that debt is due in the short term.
- Whether the company is likely to be able to easily borrow money if it needs to.
Although the balance sheet contains a lot of useful financial information, it doesn’tshowthe company’s income, expenses or cash flow. To analyze those, you need to look at thecompany’s other two financial statements. Income and expenses can be found on theincomestatement, and changes to available cash are shown on the cash flow statement.
However, the company’s net profits in any specific reporting period are reflected inthebalance sheet at the end of that period, where they appear as increases inshareholders’equity.
Video: What Is a Balance Sheet?
Importance of a Balance Sheet
The balance sheet provides business managers and investors with the information they need tounderstand the company’s long-term financial soundness and resilience. In conjunctionwithother sources of information, it can also provide business managers and investors a pictureof the company’s efficiency and rates of return on equity and assets.
Liquidity.
Because the balance sheet identifies current assets and liabilities separately fromlonger-term assets and liabilities, it can easily be used to calculate liquidity ratios such asthe current ratio and the quick (“acid test”) ratio. These ratios show how easyit would befor the company to raise cash from the sale of short-term assets, which could be crucial forits survival in the event of a sudden business interruption or economic downturn.
Leverage.
The balance sheet can also be used to gain a view of how much debt the company has inrelation to its assets. The balance sheet can be used to calculate three key ratios: thedebt/assets ratio, the equity/assets ratio, and the debt/equity ratio. The formulas forthese ratios are:
Debt to assets ratio =(Short-term debt + long-term debt) / Total assets
Equity to assets ratio =Shareholders’ equity / Total assets
Debt to equity ratio =Total liabilities / Shareholders’ equity
All of these ratios measure some aspect of the company’s “gearing.” Gearingis the extent towhich a company’s activities are funded by debt rather than by its own funds. Thehigher thegearing, the more highly leveraged the company is and the more vulnerable it is to shockssuch as economic downturns.
The balance sheet can also be used to calculate another widely used measure of financialleverage, net debt:
Net debt = Totalliabilities – Cash and Cash equivalents
Net debt shows how much of the company’s overall indebtedness could be eliminated byliquidating current assets. A high net debt indicates that the company is highly leveragedand could be vulnerable to any financial setbacks.
Efficiency.
When combined with other business information, the balance sheet can provide insights intothe company’s operating efficiency. It can be used to calculate key efficiency ratiosincluding the inventory turnover ratio, asset turnover ratio and receivables turnover ratio.
The inventory turnoverratio shows how well the company manages its inventory, which can be a drain oncapital if not managed efficiently. The higher the ratio, the more efficient the inventorymanagement.
To calculate inventory turnover ratio, start by calculating the average inventory in a periodby dividing the sum of the beginning and ending inventory by two:
Average inventory =(beginning inventory + ending inventory) / 2
You can use ending stock in place of average inventory if the business does not have seasonalfluctuations. More data points are better, though, so divide the monthly inventory by 12 anduse the annual average inventory. Then apply the formula for inventory turnover:
Inventory Turnover Ratio= Cost of Goods Sold / Avg.Inventory
COGS can be found on the income statement. Average inventory can be calculated by addingtogether inventory on the current and previous balance sheets and dividing by two.
The asset turnover ratio shows how effectively the company generates salesrevenue from its assets. The higher the ratio, the more efficiently the company is deployingits assets to generate sales. The formula is:
Asset turnover ratio =Net sales / Average total assets
To get the correct result, you need the average value of assets during the period, not thetotal value at the end of the period. Net sales can be found on the income statement andaverage total assets on the balance sheet.
The receivables turnover ratio shows how effective the company is atcollecting money after extending credit to customers. The higher the ratio, the better thecompany is at managing its trade credit. The formula is:
Receivables turnover ratio= Net credit sales / Averageaccounts receivable
A business can find net credit sales by reviewing sales with the help of accounting software.Average accounts receivable can be calculated by adding together the accounts receivablefrom the current and previous balance sheets and dividing by two.
Rates of Return. Balance sheet information is used to calculate key rates ofreturn for investors: return on equity (ROE), return on assets (ROA) and return on investedcapital employed (ROIC).
Return on equity (ROE) shows how effectively the companygenerates income from its shareholders’ investment. ROE is the ratio of net income toshareholders’ equity:
ROE = Net income / Shareholders’ equity
Net income is the bottom line of the income statement, and shareholders’ equity comesfromthe balance sheet. Usually, ROE is calculated using average shareholders’ equity. Tocalculate average shareholders’ equity over a single year, add together the startingandclosing equity positions for the year and divide by two.
Some companies report return on tangible equity (ROTE). ROTE is the ratio of net income totangible equity, which is the portion of shareholders’ equity that supports thecompany’stangible asset base. It is usually calculated as shareholders’ equity minus preferredstock,goodwill and other intangible assets.
Return on assets (ROA) shows the company’s ability togenerate income from its assets. ROA is the ratio of net income to total assets:
ROA = Net income / Total assets at the end of the periodor Average assets for the period
Net income is the bottom line of the income statement, and total assets come from the balancesheet. Sometimes, companies report return on tangible assets (ROTA), which excludes goodwilland other intangible assets.
Return on invested capital employed (ROIC) is a wider measure thatdemonstrates the efficiency of total capital invested in the business. ROIC is the ratio ofnet operating profit after tax (NOPAT) to capital invested in the business:
ROIC = NOPAT / Capital invested
NOPAT can be calculated by deducting taxes paid from operating profit: both figures can befound on the income statement. Capital invested is the sum of equity and debt afterdeducting non-operating assets and liabilities. These are assets that are not currentlybeing used to support the company’s operations, such as undeveloped land, spareequipment,unallocated cash and investment securities, as well as any liabilities associated with theseassets.
Basic Balance Sheet Formula
Assets
Assets are everything the company owns. Cash, securities, real estate, machinery and officeequipment are all assets. So too are debts owed to your company by other companies orindividuals. So, if you extend credit to your customers, the money they owe under thosecredit agreements is an asset. Advance payments toward future expenses are also assets.
Liabilities
Liabilities are what your company owes to other companies or individuals. For example, if youpurchase supplies on 90-day credit terms, the money you owe to your suppliers under thoseagreements is a liability. So too is any money you have borrowed from banks or investors.
Shareholders’ equity
Shareholders’ equity is the difference between assets and liabilities. It’s alsoknown as thecompany’s “net worth.” You can regard it as the money the company wouldhave left if itsettled all current and future claims. Ultimately, this money belongs to the company’sowners, which is why it is called “shareholders’ equity.”
In a healthy company, total assets are worth more than total liabilities, soshareholders’equity is positive. But when a company’s total assets are worth less than its totalliabilities, shareholders’ equity is negative. This situation is called balance sheetinsolvency, and it can be a warning sign that the company may eventually be unable to payits debts.
Structure of a Balance Sheet
A corporate balance sheet consists of three main sections, each of which corresponds to aterm in the balance sheet formula:
- Assets
- Liabilities
- Shareholders’ equity
Assets
Assets are divided into two categories: current and non-current (or long-term). Thesecategories are then subdivided to include things like:
- Accounts receivable
- Investments. These can be included under both current and non-current assets, dependingon the nature and purpose of the investment.
- Property, plant and equipment (PP&E). PP&E is a subcategory of non-currentassets and isn’t always used.
- Intangible assets
- Right of Use (ROU) assets
ROU Assets are leased assets, like office space, and under U.S. GAAP companies must accountfor these on their balance sheet (see ASC 842). Note: Companies must also record the unpaidportion of any leases as liabilities on the balance sheet.
The order in which these classifications appear on the balance sheet reflects their liquidityor the ease with which they can be converted to cash.
Current assets are liquid assets, meaning they can be converted into cash in oneyear or less. They include, in descending order of liquidity:
- Cash, and cash equivalents such as short-term certificates of deposit.
- Securities that can be readily traded for cash, usually on a regulated exchange.
- Accounts receivable, which is money owed to the company by its customers under creditagreements falling due within one year.
- Inventory
- Any expenses that the company has paid in advance. When taxes are paid in advance, oroverpaid due to losses carried forward, the prepayment asset is called a “deferredtaxasset” (DTA).
Again, there are two categories of assets (current and non-current) and multiplesubcategories. Non-current or long-term assets are sometimes called Fixed Assets on thebalance sheet, in which case, they include both tangible and intangible assets.
Intangible assets include:
- Goodwill, which is recorded when the company acquires another company or its assets andpays more than the fair market value of the acquired assets. Goodwill is the excessamount paid over and above the value of the assets.
- Patents, trademarks or other intellectual property acquired by the company from a thirdparty.
Liabilities
Liabilities are divided into current liabilities and long-term/non-current liabilities.Current liabilities are shown on the balance sheet before long-term liabilities.
Current liabilities can include:
- Short-term debt, such as a line of credit.
- Accounts payable, which includes bills for any goods or services purchased by thecompany, including utility bills.
- Trade payables, which is money the company owes to its suppliers under trade creditagreements falling due within one year.
- Principle and interest payment on long-term debt (loans, bonds and notes) that is due tobe repaid within one year.
- Customer prepayments
- Wages and benefits
- Short-term lease liability
- Pension contributions
- Federal and local taxes
Long-term liabilities include:
- Long-term debt (loans, bonds and notes) due in a year or more
- Long-term lease liabilities
- Long-term pension fund liabilities
- Deferred tax liabilities (taxes that have been accrued but will not fall due within oneyear)
Shareholders’ Equity
Shareholders’ equity is calculated as total assets minus total liabilities. It is thevalueof the company’s assets after all liabilities are settled. It is also known as netassets,net worth or book value. It usually consists of the following items:
- Share capital
- Retained earnings
Share capital is the capital contributed by shareholders through their purchases ofcompany shares.
Retained earnings are net profits that are not returned to shareholders in the formof dividends but are retained in the business for future investment.
Example of a Balance Sheet
To better understand balance sheets, let’s walk through two quick examples.
Example 1: Small company
A typical small company balance sheet might look something like this:
| Balance Sheet | |
|---|---|
| Current assets | |
| Cash and cash equivalents | $50,000 |
| Accounts receivable | $100,000 |
| Inventory | $100,000 |
| Total current assets | $250,000 |
| Non-current assets | |
| Equipment | $250,000 |
| Total assets | $500,000 |
| Current liabilities | |
| Short-term debt | $10,000 |
| Accounts payable | $90,000 |
| Non-current liabilities | |
| Long-term loans | $250,000 |
| Total liabilities | $350,000 |
| Net assets | $150,000 |
| Shareholders’ (Owners’) equity | |
| Share capital | $100,000 |
| Retained earnings | $50,000 |
| Total equity | $150,000 |
Example 2: Large corporation
Large corporations usually have more complex balance sheets than small companies.Below is a typical large corporation balance sheet.
| Walgreen Boots Alliance, August 31, 2020 Allamounts in $millions | |
|---|---|
| Assets | |
| Current assets | |
| Cash and cash equivalents | 516 |
| Accounts receivable, net | 7,132 |
| Inventory | 9,451 |
| Other current assets | 974 |
| Total current assets | 18,073 |
| Non-current assets | |
| Property, plant and equipment, net | 13,342 |
| Operating lease right-of-use assets | 21,724 |
| Goodwill | 15,268 |
| Intangible assets, net | 10,753 |
| Equity method investments | 7,338 |
| Other non-current assets | 677 |
| Total non-current assets | 69,102 |
| Total assets | 87,175 |
| Liabilities and equity | |
| Current liabilities | |
| Short-term debt | 3,538 |
| Trade accounts payable | 14,458 |
| Operating lease obligation | 2,426 |
| Accrued expenses and other liabilities | 6,539 |
| Income taxes | 110 |
| Total current liabilities | 27,071 |
| Non-current liabilities | |
| Long-term debt | 12,203 |
| Operating lease obligation | 21,973 |
| Deferred income taxes | 1,498 |
| Other non-current liabilities | 3,294 |
| Total non-current liabilities | 38,968 |
| Total equity | 21,136 |
| Total liabilities and equity | 87,174 |
Limitations of Balance Sheets
Balance sheets are a powerful business tool, but they still have limitations that businessleaders need to keep in mind. Key limitations include:
- The balance sheet doesn’t report the company’s current financialperformance. It doesn’tinclude information about revenue or expenses, and it only reflects profit to the extentthat it affects shareholders’ equity.
- The balance sheet doesn’t show cash movements in and out of the business during atrading period.
- A single balance sheet doesn’t tell you how a company’s financial positionhas changedover time, which can provide a better indication of the company’s futureprospects. Todetermine that, you need to examine balance sheets from several different periods. Somecompanies facilitate this when they report their balance sheet by including comparisonswith earlier balance sheets.
- Some items on a balance sheet, such as depreciation and goodwill, depend on theaccounting policies adopted by the company and on managers’ own assessments. Theycouldtherefore be manipulated to provide a misleading picture of a company’s financialposition. For example, if reducing the value of goodwill because of poor performance byan acquired subsidiary would render the parent companytechnically insolvent, management might decide to delay that impairment in thehope that the subsidiary’s performance improves.
To obtain a full picture of the company’s financial health, balance sheets must beanalyzedin conjunction with the company’s income statement and cash flow statement, the notesto theaccounts, and with other financial information.
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How to Prepare Your Business’s Balance Sheet
It’s generally straightforward to prepare a company’s balance sheet. Here’sa guide to whereto find the information for each line in a typical balance sheet (as shown in thedownloadable template).
Assets
- Cash and cash equivalents: Add together the balances in thecompany’schecking and instant-access deposit accounts, petty cash and any checks from customersthat haven’t been deposited yet.
- Accounts receivable: The total amount that your company has billedcustomers but hasn’t yet received.
- Inventory: The total value at market price of all the products youcurrently have available for sale, plus raw materials and work in progress.
Add together items 1-3 to determine your Current Assets.
- Equipment: The total purchase cost of the items minus any depreciationor amortization.
Item 4 represents your tangible non-current assets. If you have purchasedpatents or trademarks, create item 5, “Intangible assets” andenter thetotal cost of acquiring them or their amortized value, if it differs from their acquisitioncost. The value of intangible assets is amortized in much the same way as tangible assetsare depreciated.
Total Assets are the sum of items 1-4, or 1-5 if you have intangible assets.
Liabilities
- Short-term debt: Add together your company’s current bankoverdraft,the balances outstanding on any business credit cards, and the total amount of all loansdue for repayment within a year.
- Accounts payable: The total amount of any supplier invoices that youhaven’t yet paid.
Add together items 5-6 to give your Current Liabilities.
- Long-term debt: The total amount of loans, from any source, due forrepayment in more than one year.
The sum of items 5-7 is your Total Liabilities.
To calculate your Net Assets, subtract Total Liabilities from TotalAssets.
- Owners’ equity: The total amount that the company’s ownershaveinvested in the company.
- Retained earnings: You can calculate this using this formula:
Retained earnings= Total assets –(Totalliabilities + owners’ equity)
The sum of items 8-9 is your Total Equity. It should be the same as yourNet Assets.
How to Create Balance Sheets
You can create balance sheets manually via spreadsheets or with accounting software.
Manually: Creating a balance sheet manually can sound daunting, but the daysof quill pens and physical ledgers are long gone. Today, you can create a basic balancesheet with a standard spreadsheet-based template, as long as your business isn’t toocomplicated. You’ll need to gather the following documents to find the requiredinformation:
- Bank statements
- Records of accounts payable and accounts receivable
- Statements for any outstanding loans
- Receipts for asset purchases or other documentation of asset value
- A complete current inventory record
Software: Although it may not be complicated to create a balance sheetmanually, it is definitely time-consuming—and you’ll have to reenter much of theinformationevery time you go through the process. So as your business grows and you get even busier,you might decide it’s best to use accounting software,which will record all your company’s financial transactions and automatically generatefinancial reports from them. This can make it much faster and easier to produce a balancesheet, and it can increase accuracy since no one is manually inputting data (and potentiallymissing a zero or decimal point).
Free Balance Sheet Template
You can start creating your own balance sheets today with this downloadablebalance sheet template.
Download thetemplate
The balance sheet is one of the company’s most important financial statements. Itprovides asnapshot of a company’s financial position by showing its assets, liabilities andshareholders’ equity. However, it doesn’t show the company’s income,expenses or cash flow,and it doesn’t show how the company’s financial position has changed over time.To get amore complete view of a company’s financial health, you need to analyze the currentbalancesheet alongside other documents like the income statement, cash flow statement and balancesheets from earlier periods.
