Possession is something you own and that adds value to your life, whereas debt is something you must pay back to the lender. These two opposite concepts apply to both individuals and businesses. How does one understand a company's possessions and debts? Simply by looking at its balance sheet. Let's examine the balance sheet in more detail.
Balance Sheet: Definition
A balance sheet is a type of financial statement.
The balance sheet tells us the value of a business at a certain point in time. It shows what the company owns (assets) and owes to others (liabilities).
The balance sheet is one of the three main financial statements of a business, along with the income statement and cash flow statement.
By looking at a balance sheet, we can identify a company's finance source and how it spends its money. A balance gives us a snapshot of a business's financial position at a particular time.
The three main components of a balance sheet are assets, liabilities, and equity:
Assets are what the company owns, such as buildings, stock, or cash.
Liabilities are what the company owes to creditors and banks, such as bank loans or unpaid bills.
Equity is anything invested in a company by its owners.
Structure of a balance sheet
Figure 1 shows the overall structure of a company's balance sheet with assets, liabilities, and equity.
| Balance | Sheet |
|---|
| Assets | Liabilities |
| Current Assets | Equity |
| Fixed Assets | Lont-Term Equity |
| Current Liabilities |
Table 1 - Balance Sheet Structure
Balance Sheet: Assets
Assets are anything that a business owns. They can be classified into fixed assets and current assets.
Fixed assets (or non-current assets) are a company’s possessions that will not be sold in the near future. They tend to last for a long time and are used to produce goods or services. Fixed assets are not easily converted into cash.
Machinery, buildings, land, vehicles, computers, equipment, furniture, software, etc.
Current assets are a company’s possessions used in production or to pay for raw materials. Unlike fixed assets, they are only held for a short period of time. Current assets are easily converted into cash.
Cash, inventory, stock, accounts receivable (money to be paid by customers).
Balance Sheet: Liabilities
Liabilities are what a company owes to creditors or the bank. They can be divided into current liabilities and long-term liabilities.
Current liabilities are what a business owes in the short run. These are debts that will be paid back within a year.
Short-term loans (overdrafts), accounts payable (money owed to the suppliers), taxes, and dividends (profits distributed to shareholders).
To calculate net current assets:
Long-term liabilities are what a business owes in the long run. These are debts that will be paid back over many years, for example, bank loans or mortgages (loans to purchase property).
To calculate the overall wealth of a business:
Balance Sheet: Total equity
Total equity is a business's capital that belongs to shareholders. This is the money remaining if the business uses up all its assets. In this case, total equity is used to pay for the company's debts.
The total equity can come from:
Equation of a balance sheet
‘Balance’ means that two things should be equal. The balance sheet is so-named because each part of the document is equal to the other.
'Net assets employed' refers to the value of assets belonging to the business. This is the exact amount of money invested in the business by the shareholders, known as total equity or capital employed.
Thus, the equation of the balance sheet:
Since Net assets = Assets - Liabilities, we also have:
How do you interpret a balance sheet?
The balance sheet is one of the documents that a business's stakeholders, such as managers, suppliers, and owners, will be most interested in. An investor also may want to read and analyse a company's balance sheet before investing in its stock.
The balance sheet shows how the value of a company has changed by comparing the 'net assets employed' of the current year with the previous years. An increase in assets is generally a good sign, as it indicates growth. However, you need to look more into a balance sheet's structure to see what really happens behind the scenes.
A balance sheet is divided into two main sessions: Assets and Liabilities and Equity. In all balance sheets, the value of assets is always equal to the combined value of Liabilities and Equity.
Another way to analyse a balance sheet is to use ratios such as financial strength ratios and activity ratios. Financial strength ratios include working capital and debt-to-equity ratios, which show how financially stable a company is and how it finances itself. Activity ratios indicate the efficiency of a company's operations. These include inventory turnover, accounts receivable, and payables.
To learn more about ratio calculations, check out our explanation on Financial Ratios!
Balance sheet example
Now that we’ve learned different components of the balance sheet and how to interpret it, let’s consider an example:
C Corporation sells sustainable activewear products. Figure 2 shows the business’s balance sheet for 31 December 2021.
| ASSETS | £ million | | LIABILITIES | £ million |
| Current Assets | | | Current Liabilities | |
| Cash | 50 | | Accounts Payable | 75 |
| Accounts receivable | 100 | | Interest and taxes | 10 |
| Stock | 60 | | Overdraft | 10 |
| Total Current Assets | 210 | | Total Current Liabilities | 95 |
| | | | |
| Fixed Assets | | | Long-term Liabilities | |
| Buildings | 100 | | Bank loans | 50 |
| Furniture | 50 | | Total long-term liabilities | 50 |
| Equipment | 50 | | | |
| Total Fixed Assets | 200 | | Shareholders' equity | |
| | | Share capital | 100 |
| | | Reserves | 30 |
| | | Retained earnings (profit) | 135 |
| | | Total Shareholders' Equity | 265 |
| | | | |
| TOTAL ASSETS | 410 | | TOTAL LIABILITIES & EQUITY | 410 |
Table 2 - Balance Sheet Example
As you can see in Figure 2, the total assets of C Corporation equal its total liabilities and equity, around £410 million. The balance sheets also reveal the value of assets, shareholders' equity, and how much a company owes to others (liabilities). A further look into C Corporation's assets and liabilities shows its current assets, fixed assets, and the money it has to pay in the short and long run.
Along with the income statement and cash flow statement, the balance sheet is one of the most important tools for stakeholders to assess a company's value and growth potential. It provides a snapshot of a company's financial position through its assets, liabilities, and equity. Let's wrap up this explanation with a few key takeaways.
Balance sheet - Key takeaways
- A balance sheet shows what a company owns and owes to others. It gives us an overall picture of a company's wealth.
- A balance sheet consists of assets, liabilities, and equity.
- Assets are what the company owns, including current assets and fixed assets.
- Liabilities are what the company owes to creditors or banks, including short-term liabilities and long-term liabilities.
- The equation of the balance sheet is determined by considering the money needed to cover a company's net assets.
- Net assets = Equity or Total Assets = Total Liabilities.
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