A balance sheet is one of the key financial statements provided by a company. Along with the income statement and the statement of cash flows, the balance sheet helps provide a picture of the company's financial position at given point in time.
What Is a Balance Sheet?
The three broad balance sheet categories are:
Assets represent what the company owns. The asset classifications that you are likely to see on a balance sheet are:Current Assets
Current Assets are assets that convert to cash or that will be used within the next year. Current assets might include:
- Accounts receivable
- Pre-paid insurance
Investments are assets that represent investments of a longer-term nature, which could include:
- Long-term investments like stocks and bonds
- A sinking fund used to retire a bond offering
- The cash value of a life insurance policy owned by the company
- Funds being held to fund a construction project
These include long-term, more permanent assets such as:
- Equipment and machinery used in the business
- Furniture and fixtures
- Trucks and other vehicles
Intangible assets are non-physical assets of the business that have value such as:
- Copyrights on a product or service name
- Brand names
- Domain names
Other Assets are those that don't fit into any of the above categories. An example would be the costs of a bond issuance that are being amortized over the life of the bond offering.
Liabilities are amounts owed to creditors by the company. The liability classifications you are likely to see on the balance sheet typically include:Current Liabilities
Current Liabilities are those that will come due within a year. Typical items in this category include:
- Accounts payable
- Customer deposits, these may be used to hold an item for a customer or a payment to be returned to a customer if they meet certain terms.
- Sales taxes payable, these are sales taxes collected from customers that need to be remitted to the proper taxing authority by the company.
- Accrued expenses that have not yet been paid but have been accrued.
- Wages payable, they have been accrued but not yet paid.
Long-Term liabilities are those that are not due within a year of the date of the balance sheet. Some examples include:
- Bonds payable
- Long-term debt payable
Owner's equity represents the book value of the company. It can also be called stockholder's equity. Equity denotes ownership in a company. Some classifications in the owner's equity situation might include:
Common stock is the share class that represents ownership of the company, including the right to elect the board of directors. In the event of liquidation, common shareholders fall behind bond holders, preferred shareholders and most other creditors in terms of having a claim on the company's assets.
Preferred stock is a share class in which the shareholders receive preferential treatment in the payment of dividends. Retained earnings which are the earnings of the corporation to-date less dividends paid to-date.
Retained earnings are the earnings of the corporation to-date less dividends paid to-date.
What Is the Balance Sheet Equation?
The balance sheet equation is both simple and impactful:
Assets - liabilities = owner's equity
Put another way, this says that owner's or shareholder's stake in the company is what's left after what the company owes various creditors is subtracted from what it owns. For example, if a company's assets are $250 million and its overall liabilities are $150 million, then owner's equity is valued at $100 million.
Importance of a Balance Sheet
Many experts deem the balance sheet to be the most important financial statement to monitor. During the Dot Com bubble and subsequent stock market meltdown from 2000-2002, some analysts pointed to "companies without meaningful balance sheets" as a contributing factor to this market decline.
The balance sheet is a snapshot of the company's financial position at a given point in time. It details what the company owns, what it owes and the owner's equity in the company.
Looking at the balance sheet, if a company's liabilities are greater than its assets, the shareholders have negative equity in the company. While this is an extreme situation, it speaks volumes as to the poor financial health of a company.
A number of key company financial ratios and indicators are derived from the balance sheet.
Key Balance Sheet Financial Ratios
Balance sheet data is a source of many key financial ratios that are used to analyze a company. These include:
- Current ratio - Current assets divided by current liabilities. A current ratio of less than 1 means that a company might not have sufficient liquidity to meet its current obligations. There is no right answer, but a current ratio that is too high might point to a company that is not using enough financial leverage in its capital structure.
- Debt to equity ratio compares the company's liabilities to its shareholder's equity. There is no right or wrong answer per say, but it is useful to compare this ratio for a company to its competitors in the same industry to see if their use of debt in their financial structure is higher than average. A company using too much debt could find itself unable to repay that debt if the business runs into financial trouble. A company with a high debt to equity ratio might have trouble borrowing additional funds or will be charged a higher interest rate for a loan.
- Return on assets is calculated by dividing the company's net income by the company's total assets. This is an indicator of how efficiently the company is using its assets to generate a profit.
- Inventory turnover ratio is calculated by dividing average inventory by the cost of goods sold from the income statement. A higher turnover rate indicates that the company's inventory is moving, and the company is not tying up an excessive investment in its inventory, it can also mean that the levels of inventory are too low for the level of sales.
These and other financial ratios that are based all or in part off the balance sheet can be useful in analyzing how the company employs its assets, its liquidity and its capital structure. Ratios should be looked at over time to detect trends and compared with similar ratios of other companies in the same industry. External users such as banks and investors will look at balance sheet ratios in determining whether to invest in a company or in determining whether or not to lend a company money.
Introducing TheStreet Courses: Financial titans Jim Cramer and Robert Powell are bringing their market savvy and investing strategies to you. Learn how to create tax-efficient income, avoid mistakes, reduce risk and more. With our courses, you will have the tools and knowledge needed to achieve your financial goals. Learn more about TheStreet Courses on investing and personal finance here.