Balance Sheet

A balance sheet is the oldest form of compiling data on the financial and economic states of companies, which dates back to the late 14th century.

What Is a Balance Sheet?

In accounting, a balance sheet is an overview of a company’s financial state. It sums up the assets, equity, and liabilities of a firm or individual at a specific point in time, showing what a company owns and owes and how much shareholders have invested.

A standard BS is divided into two parts. The left part is for assets and the right part is for liabilities and ownership equity. The main categories of assets are usually listed first, followed by the liabilities. Though balance sheets can look slightly different for different types of businesses, i.e. corporations, sole proprietors, retailers, and wholesalers.

The balance sheet is based on the following accounting formula: Assets = Liabilities + Equity. It means that a company pays for everything it owns (assets) either by borrowing money (taking on liabilities) or by taking it from investors (issuing equity).

Assets, liabilities, and equity consist of multiple smaller accounts, e.g. cash account, according to the specifics of company finances. These accounts can vary by industry, and the same terms can have a different meaning.

For example, if a company takes a 10-year, $10,000 loan from a bank, its assets (specifically, the cash account) will increase by $10,000. Its liabilities (specifically, the long-term debt account) will also increase by $10,000, balancing both sides of the equation. If the company takes $20,000 from investors, its assets and equity will increase by that amount. All revenues generated by the company on top of its liabilities will go into the equity account, representing the net assets that the owners hold. These revenues will be balanced on the assets side in the form of cash, inventory, investments, or another asset.

Here’s one more example. A company needs to buy a computer. The cash in its assets decreases but the new computer asset helps to balance this. As the company sells to its customers, its profits are recorded as retained earnings in the equity section. The cash from these profits is recorded in the assets section and the sheet remains balanced. Every month the company makes a loan payment to the bank. The liabilities are decreased by the amount of this payment and the cash is decreased by the same amount.

Assets

Within the assets segment, accounts are listed from top to bottom in the order of liquidity, i.e. ability to be converted into cash. They are divided into current assets, which can be converted to cash within one year or less, and non-current or long-term assets, which cannot.

Current assets accounts include:

• Cash and cash equivalents such as treasury bills or short-term certificates of deposit.

• Petty cash – amounts of cash for making small payments.

• Accounts receivable - money owed by customers.

• Inventory – products that are available for sale.

• Supplies – the cost of supplies on hand at the point of time.

• Prepaid expenses - advertising contracts, insurance, or rent.

• Accrued revenue – revenue that has not yet been received.

• Temporary investments – investments that are planned to be sold in the nearest future.

Long-term assets can be:

• Fixed – buildings, cars, equipment, furniture, land, and other durable physical assets.

• Intangible – non-physical assets such as goodwill and intellectual property.

• Biological – live animals or plants, e.g. sheep grow to produce wool or trees grown to produce fruit.

Liabilities

Liabilities refer to the money that a company owes to outside parties, such as suppliers, creditors, and employees. They are also divided into the current and long-term. Current liabilities are due in one year and are listed according to their due date. Long-term liabilities are due after one year at any point in time.

Examples of current liabilities:

• bank indebtedness,

• current portion of long-term debt,

• customer prepayments,

• rent, tax, utilities,

• interest payable,

• wages payable,

• dividends payable,

• warranty.

Examples of long-term liabilities:

• Deferred tax liability - taxes accrued but will not be paid for another year.

• Pension fund liability - the money that a company is obliged to pay its retired employees.

Equity

Equity is the money pertaining to company shareholders and includes the following:

• Common stock – the type of stock that is present at every company.

• Retained earnings - net income that a company either reinvests in the business or uses to pay the debt. The rest is received by shareholders in the form of dividends.

• Treasury stock - the stock that a company has either repurchased or never issued. It can be sold at a later date.

• Paid-in capital – the amount paid by shareholders in exchange for company stock shares.

• Additional paid-in capital - capital that represents the surplus amount that the shareholders have invested in the common stock or preferred stock accounts.

Drawbacks of Balance Sheets

Though a balance sheet represents important information for investors, it still has certain limitations. As it represents the balance at a certain point in time, it is static, so there is an incomplete picture of what's going on with a company's business.

Besides, some accounting software enables the users to make changes to the balance sheet figures and thus the managers can adjust the numbers so that they look more favorable to the investors. Therefore, it is recommended to study the footnotes because they can give a clue about the accounting system that was used to compile the balance sheet.

Summary

In accounting, a balance sheet is an overview of a company’s financial state. It is divided into three main sections: assets (right side), liabilities (left side) and equity (left side). The balance sheet is based on the “Assets = Liabilities + Equity” accounting formula. The main drawback of a balance sheet is that it is static and thus gives an incomplete picture of what’s going on with the company.