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What is a Balance Sheet?
By definition, a balance sheet is a financial statement of all of the company's assets (what the company owns) and liabilities (what the company owes) along with the value of the shareholder's equity (a company's net worth) for a specific period. It is known as a balance sheet because it is maintained to ensure that a company's assets are always equal to the sum of liabilities and shareholders' equity.
A balance sheet is also commonly known as a statement of financial position or statement of net worth. By analyzing the statement, investors can get a snapshot of the company's financial situation at any given time. Companies can prepare the statement on a monthly, quarterly, or annual basis.
Balance Sheet Example
Now that you know what a balance sheet is, it's time to find out what goes on a balance sheet. Let's take a look at an example of Apple's 2019 balance sheet.
As you can see, it begins with Current Assets, followed by Non-Current Assets and Total Assets. Then there are Liabilities plus Stockholders' Equity with Current Liabilities, Non-Current Liabilities, and, lastly, Shareholders' Equity.
Source: Apple's 10K, Oct 31, 2019
How to Read a Balance Sheet?
As already discussed, the balance sheet is usually divided into two sections: assets and liabilities plus shareholders' equity. All the balance sheet items are sorted based on their liquidity—most liquid assets, such as cash, come first.
Assets are typically recorded on the left-hand side of the balance sheet and divided into current assets and noncurrent assets, while liabilities are grouped into current liabilities and non-current liabilities. The shareholder's equity section includes information on common stock, retained earnings, accumulated other comprehensive income, and treasury stock.
At the bottom, the value of total assets and that of total liabilities plus shareholder's equity should be equal. Every balance sheet also includes notes and footnote disclosures, which will offer crucial information regarding a company's financial situation, including potential liabilities not included in the balance sheet.
Current assets are assets that the company expects to sell or use over the next year. They consist of the most liquid assets, such as:
Cash and Cash Equivalents
Being the most liquid asset, cash is the first item on the balance sheet, along with cash equivalents, which consist of holdings with short-term maturities or that the firm can liquidate quickly, such as marketable securities. Investors can find further information about cash equivalents in the footnote disclosures.
Accounts receivables are sales made on credit, whose cash has not yet been collected by the company. When the firm receives the cash, accounts receivable decrease, while cash increases by the same amount.
Inventory consists of finished goods not yet sold and raw materials used to produce them.
Non-current assets are assets that the company doesn't expect to sell or use over the next year. They consist of less liquid assets, such as:
Property, Plant, and Equipment (PP&E)
Property, Plant, and Equipment (PP&E) consist of the business’s tangible fixed assets. Some businesses further classify their PP&E based on the different natures of assets (for example land, buildings, etc...).
Intangible assets are assets that are non-physical, such as trademarks or copyrights. Companies can also categorise intangible assets into two different groups: identifiable intangible assets, that include patents or licenses, and unidentifiable intangible assets, such as brand recognition or goodwill.
Current liabilities are obligations that must be paid over the next year. For example:
Accounts payable are payments owed to suppliers for purchases made on credit.
Current Portion of Long-Term Debt
This is the portion of long-term debt (with a maturity greater than one year) that is due within the current year. For instance, if a firm has a 10-year loan, this account includes the portion of the loan owed in the current year.
Non-current liabilities are long-term obligations that are not due within the upcoming year. They include:
This account includes the amortized amount of any bonds the company has issued.
This account includes the total amount of long-term debt (excluding the current portion, if that account is present under current liabilities). This account is derived from the debt schedule, which outlines all of the company’s outstanding debt, the interest expense, and the principal repayment for every period.
Shareholders' equity, also known as Stockholders’ Equity or Net Worth, consists of the funds with which the company has been financed. The main sources of funds for shareholders' equity are:
Share capital consists of the amount of money invested by stockholders. If an entrepreneur starts a company investing $1 million, cash (asset) grows by $1 million, and share capital (on the shareholders' equity) goes up by the same amount.
Retained earnings is the portion of net income retained by the company.
What Does A Balance Sheet Tell You?
Now that we have broken down what is included in a balance sheet, let's discuss what a balance sheet analysis can tell investors:
Liquidity Analysis: Investors can analyze a company's liquidity by comparing current assets to current liabilities. If the company's liquidity is not good enough, it could face severe difficulties in paying its current debts if its daily income stops (as in the case of a pandemic). The consequences would be even more severe in the event of a credit crunch (i.e., a sudden reduction in the general availability of loans.)
Solvency Analysis: Analyzing how a company is financed can help you evaluate the ability of a company to pay its long-term debt and the interest on that debt. A financially strong company has enough liquidity to pay its short-term obligations and, at the same time, must manage its capital structure appropriately.
Efficiency Analysis: Investors can analyze a balance sheet together with the income statement to evaluate how efficiently a business utilizes its assets. For example, the asset turnover ratio, which is equal to revenue divided by total assets, is used by investors to measure how efficiently a company is using its assets to generate revenue.
Balance Sheet Formula
As discussed above, the statement of financial position is also known as a balance sheet because it is maintained to ensure that a company's assets are always equal to the sum of liabilities and shareholder's equity. Here's the balance sheet formula:
Assets = Liabilities + Equity
The balance sheet equation states that the sum of liabilities and owner's equity is equal to the total assets owned by a company.