Updated July 7, 2023
What is Balance Sheet?
A balance sheet, also known as a statement of financial position, is one of the critical financial statements which record the assets, liabilities, and shareholder’s equity portion of a company at any specific point of time, where it serves as the foundation to calculate the rates of return and to evaluate the capital structure of the company.
Explanation
The balance sheet has also termed a statement of financial position. It gives the user a snapshot of the company’s assets, liabilities, and shareholder equity at any time. Thereby, it tells us what the company owns in the form of assets, what it owes to others in the form of liability, and finally, what the shareholder equity is or the amount invested by its shareholders. It comes in handy with other financial statements like income and cash flow. All three are somehow related to each other to finally arrive at the net cash in hand from the cash flow statement. It can be beneficial for evaluating a business. The fundamental analyst will calculate financial ratios using balance sheet components and other financial statements.
Role of Balance Sheet
Different roles are mentioned as follows:
- It tells us how much the company owes and owns. This means one can match the assets to the liabilities and estimate whether the firm has enough funds to pay its short-term obligations.
- It helps to compare the total value of debt to the total amount of equity listed to check via debt/equity, showing a warning level of excessive borrowing by the company.
- The investor would like to evaluate the amount of cash on the balance sheet to understand whether the firm can pay dividends.
- During acquisition, an acquirer would like to understand the company’s balance sheet to understand if any assets could be discarded without harming the business.
- Understanding the financial health of the firm helps.
The Formula of the Balance Sheet
The balance sheet formula serves as the base of the double-entry accounting system. It goes as follows:
- Assets – The company has to repay the things it owns and the money against it to itself.
- Liabilities – The company owes things to others and has to repay the same to others.
- Shareholder’s equity – The amount of sum invested by its shareholders.
Example of Balance Sheet
An example has been attached in the Excel file where we can see the company’s ets, liabilities, and shareholder’s equity of ng with all the components under each criterion. These can help in identifying a lot of financial ratios. For example, if we refer to the Excel file, we will find the first part of the balance sheet is the calculation of total assets. Here for the company, we have divided the total asset into two parts, i.e., current assets amounting to $5,000 and fixed assets amounting to $4,500. Thus the total asset is the sum of current and fixed assets, which is $9,500.
Next part, we look at the liabilities and shareholders’ equity part. The liabilities are again divided into current and long-term liabilities. The current liability is $1,500, and the long-term liability is $1,000, making the total liability $2,500. Coming now to the shareholder’s equity, the invested capital by the shareholder is $6,000, with retained earnings and other earnings amounting to $1,000. Thus the total shareholder’s equity is $7,000. So now we see both equal assets and liabilities plus shareholder’s equity which amounts to $9,500.
How to Construct a Balance Sheet?
The steps are as follows to prepare a balance sheet for a company:
- First, we need to use the basic accounting equation to prepare a balance sheet stating that assets are equal to the sum of liabilities and shareholder’s equity.
- We need to choose the date of preparation of the balance sheet because the balance sheet is a statement of a company’s financial position on a specific date. Usually, it’s quarterly at the end of a financial year.
- We need to decide on the headers of the balance sheet, where we write the balance sheet’s title on top, followed by the company name underneath and the date.
- We first need to prepare the asset section, where we need to list all the assets available with the company, starting with current assets, which can be converted into cash within a year.
- Next, we need to list the non-current or fixed assets available with the company, like buildings, plants, and machinery that can be used for more than a year.
- We should also include all intangible assets like patents, copyrights, and trademarks.
- After adding all the types of assets, we finally arrive at the total assets, which we write at the bottom of the balance sheet on the left-hand side.
- Next comes the preparation of the liability section on the right-hand side, which starts with current liabilities like accounts payable and short-term notes, generally due within one year.
- After this, we record the long-term liabilities, also called fixed liabilities, that need to be settled over one year or more, like long-term notes, pensions, bonds payable, etc.
- After adding both liabilities, we arrive at the total liabilities amount.
- The last part to be calculated just below the total liability is shareholder’s equity, where the retained earnings are first calculated.
- Next, we calculate the owner’s equity, the sum of contributed capital, and retained earnings.
- Last, the total shareholder’s equity and total liability are added and placed at the bottom of the left-hand side. This total on the right-hand side should match the total assets on the left-hand side.
Importance and Uses
- It helps to determine the business’s financial position at any time.
- It tells us the structure of the assets and liabilities of the company.
- This helps analysts calculate various financial ratios to understand the company’s health.
- It can tell investors if the company is capable enough to pay dividends.
- It acts as crucial document banks require to get a business loan approved.
Benefits
Some of the benefits are given below:
- It is one of the essential tools investors, creditors, and shareholders use to understand the business’s financial health.
- One can determine the company’s growth rate by comparing the balance sheet for several years.
- One can determine whether a company funds its operations from its profit or debt from the balance sheet.
- It shows that the company is living on debt or has enough equity.
- It tells whether a company can expand or meet unforeseen expenses.
- This gives stakeholders an accurate picture of the company’s liquidity or business performance.
Disadvantages
Some of the disadvantages are given below:
- The accounting only considers the acquired assets, while the internally developed ones are not.
- The company mistakenly stated long-term assets by recording them at their historical or book value instead of the current market price.
- It is made on a specific date, and thus it is not real-time. The management may choose a favorable date when things are going fine to make their balance sheet.
- It needs comparison to be effective; To reach a comparable position, one must compare the balance sheet with the competitors.
Conclusion
It is crucial for other financial statements and bridges between profit and loss statements and cash flow. In addition, it is a snapshot of the firm’s health and current financial position on a specific date. A balance sheet, in simple words, tells us how much a company owns and how much it owes.
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