A balance sheet provides a snapshot view of a company’s assets, liabilities and equity at a given moment, showing the balance between income and expenditure. It is also known as a “statement of financial position.” When using a correct and precise balance sheet, a company’s owner can see what his company is worth, what he owns and what he owes all at a glance.
This is the simple equation that defines a balance sheet:
Assets = Liability + Shareholders’ Equity
Assets are what the business owns–anything that can be used to make money. These can include cash, marketable securities, accounts receivable, inventory, investments, and other fixed assets such as land, property, buildings, equipment, and so on.
Liability describes the money that a business or company owes. This includes salaries, rent, taxes and utilities, payments to suppliers as well as loans and long-term debt.
When calculating a company’s equity, the answer is found by subtracting the liability from the assets. Whatever is leftover is the equity. This describes what the company is worth, the amount of money attributable to the company’s shareholders. It is also known as “net assets.”
When all the numbers are added up, both sides of the equation should equal each other, making the equation balanced–thus the name of the calculation.
Balance sheets are helpful in allowing a company to have a quick overview of its financial status, as well as providing information needed for several different ratios, including the acid test ratio and the debt to equity ratio. The acid-test ratio helps a company determine if it has enough short-term assets to cover its immediate liabilities.
Note that a balance sheet is a snapshot in time. The balance sheets that you see public companies filing as part of their financial statements, are as of the end of the fiscal quarter and represents the value of assets and liabilities as of that day. It is useful for shareholders to compare different balance sheets over a period of time and see how critical values for the company have been changing. Are the managers creating more shareholder’s equity or are they eroding it?
Keep this in Mind while Reading a Balance Sheet
Consider a company that buys inventory regularly and uses it to build a product. The market cost of the inventory changes every day. After a while, the inventory that is held in the business is a mish mash of stuff bought at different prices, and unless you have a good system to keep track of what is being bought and what is being used and sold, it can become really difficult to accurately track the costs and the value of the inventory held.
How about the expensive equipment that the company bought 5 years ago for a million dollars? Should we still value this asset at a million dollars or should we allow for the fact that over time and after some wear and tear, the equipment is no longer worth the price we paid for it?
The US Generally Accepted Accounting Principles (GAAP) has specific suggestions and requirements on how value of declining assets and inventory needs to be tracked over time. This is accomplished by using different depreciation schedules and different inventory accounting methods. So in many ways, knowing the numbers on the balance sheet, while important, may not be enough to get the accurate picture of a business – one also needs to know how these numbers are being arrived at.
There are also situations where an asset value on the balance sheet may vary significantly from its current market value. When this happens, the businesses will eventually mark the asset to the market by taking a charge (most often the case). A good investor will account for the value variance.
Keeping track of finances for business owners/managers as well as the investors in a company, is vital. By running numbers through a balance sheet and an income statement, owners and shareholders have the opportunity to adjust as needed, improve cash flow and make their business more profitable overall. Balance sheets are a simple tool that can provide a wealth of information on a company’s financial standing. Utilizing this tool can help boost productivity and give owners a clearer picture of what needs to be done to bring their business to its most efficient and effective level.
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