The balance sheet is a document that summarizes the overall financial status of a business. It is a static document that provides this information at a specific point in time.
By providing detailed information at a fixed point in time, the balance sheet provides a snapshot of the business and its key financial indicators.
Information in the balance sheet represents the three fundamental accounting measures:
Assets—any resource of monetary value that the business owns
Liabilities—any amount that the business owes to another party
Equity—the financial stake in the business that its owners are entitled to after all liabilities are accounted for
All information in the balance sheet is arranged according to these three categories.
The balance sheet is an important document that provides useful information about the financial status of the business to investors.
They can extract valuable information from the balance sheet that helps them assess the health and performance of the business.
Investors generally use information in the balance sheet to make one of four evaluations about the business:
What are the business’s liquid assets (assets that are easily converted to cash)?
How much has the business financed, or borrowed, to support its operations?
Is the business making an efficient use of assets?
Is the business generating a good rate of return?
The balance sheet is one of four financial statements that are typically generated for a business. The other statements are cash flow statements, income statement and the statement of owner’s equity.
The balance sheet is organized around the fundamental accounting equation, which is represented as: Assets = Liabilities + Equity. Therefore, all data in the balance sheet is arranged according to these three categories.
Assets are typically listed first, followed by liabilities and equity. Sometimes assets are listed in the left column, and liabilities and equity are listed on the right.
While the balance sheet reduces the business’s finances into a simple equation, the document itself is anything but simple. Within each category of the balance sheet are more specific categories. Each has very specific, detailed information about the business.
For example, assets include many different types of financial resources, such as current assets, non-current assets, fixed assets, and prepaid assets. Examples of assets include cash, inventory, accounts receivable, and property.
Liabilities can include such financial obligations as accounts payable, accrued expenses, unearned revenue, and long-term debt (loans).
Equity can be broken down into preferred stock, common stock, and retained earnings.
In the fundamental accounting equation, both sides must balance out. Therefore, in the balance sheet, a business’s total assets must equal the sum of its liabilities and equity. The accounting equation reflects the double-entry accounting system, which operates on the principal that all transactions are entered in at least two places in the accounting records for the business, and those two entries will always cancel out.
For example, if a business buys $100,000 worth of raw materials for production, the value of those materials will be represented in the balance sheet as an asset in the form of $100,000 worth of inventory, and as a liability in the form of a $100,000 cash payment or an accounts payable entry of the same amount.
Investors typically make calculations, or ratios, to help them evaluate the information in the balance sheet.
The debt-to-equity ratio reveals if a business is borrowing too much
The working capital ratio measures whether the business has sufficient assets that can be easily converted to cash, and therefore is able to pay off short-term liabilities
The quick ratio, or acid test, factors the business’s inventory into its ability to pay off liabilities because inventory is an asset that is not easily converted to cash
Earnings per share (EPS) measures the net income earned on each share of a company's common stock
The price-earnings ratio (PE) expresses the EPS in proportion to the price of the company’s stock
Return on equity (ROE) measures the net earnings of a business in proportion to its total equity
A balance sheet can be generated at any time. It is typically generated at the end of an accounting period such as the end of the month, quarter, or year.
The balance sheet is not just important to investors. The information in the balance sheet is also important to banks that are considering issuing a loan to the business.
The balance sheet will provide important insight into the business’s loan risk, or its ability to repay the loan.
The balance sheet is also important to tax regulators, such as the IRS, in evaluating the financial position of the business, which may be relevant to an analysis of the business’s ability to pay off tax debt.
The balance sheet provides a snapshot of the business at a specific point in time, which is whenever the balance sheet is generated, for a month, quarter, or year. For this reason, it cannot analyze trends, which are patterns of financial activity over time. In contrast, cash flow and income statements reveal information about the business over time.