how balance sheets work
the balance sheet provides an overview of the state of a company s finances at a moment in time it cannot give a sense of the trends playing out over a longer period on its own for this reason the balance sheet should be compared with those of previous periods investors can get a sense of a company s financial well being by using a number of ratios that can be derived from a balance sheet including the debt to equity ratio and the acid test ratio along with many others the income statement and statement of cash flows also provide valuable context for assessing a company s finances as do any notes or addenda in an earnings report that might refer back to the balance sheet the balance sheet adheres to the following accounting equation with assets on one side and liabilities plus shareholder equity on the other balance out this formula is intuitive that s because a company has to pay for all the things it owns assets by either borrowing money taking on liabilities or taking it from investors issuing shareholder equity if a company takes out a five year 4 000 loan from a bank its assets specifically the cash account will increase by 4 000 its liabilities specifically the long term debt account will also increase by 4 000 balancing the two sides of the equation if the company takes 8 000 from investors its assets will increase by that amount as will its shareholder equity all revenues the company generates in excess of its expenses will go into the shareholder equity account these revenues will be balanced on the assets side appearing as cash investments inventory or other assets balance sheets should also be compared with those of other businesses in the same industry since different industries have unique approaches to financing special considerationsas noted above you can find information about assets liabilities and shareholder equity on a company s balance sheet the assets should always equal the liabilities and shareholder equity this means that the balance sheet should always balance hence the name if they don t balance there may be some problems including incorrect or misplaced data inventory or exchange rate errors or miscalculations each category consists of several smaller accounts that break down the specifics of a company s finances these accounts vary widely by industry and the same terms can have different implications depending on the nature of the business companies might choose to use a form of balance sheet known as the common size which shows percentages along with the numerical values this type of report allows for a quick comparison of items there are a few common components that investors are likely to come across theresa chiechi copyright investopedia 2019 components of a balance sheetaccounts within this segment are listed from top to bottom in order of their liquidity this is the ease with which they can be converted into cash they are divided into current assets which can be converted to cash in one year or less and non current or long term assets which cannot here is the general order of accounts within current assets long term assets include the following a liability is any money that a company owes to outside parties from bills it has to pay to suppliers to interest on bonds issued to creditors to rent utilities and salaries current liabilities are due within one year and are listed in order of their due date long term liabilities on the other hand are due at any point after one year current liabilities accounts might include long term liabilities can include some liabilities are considered off the balance sheet meaning they do not appear on the balance sheet shareholder equity is the money attributable to the owners of a business or its shareholders it is also known as net assets since it is equivalent to the total assets of a company minus its liabilities or the debt it owes to non shareholders retained earnings are the net earnings a company either reinvests in the business or uses to pay off debt the remaining amount is distributed to shareholders in the form of dividends treasury stock is the stock a company has repurchased it can be sold at a later date to raise cash or reserved to repel a hostile takeover some companies issue preferred stock which will be listed separately from common stock under this section preferred stock is assigned an arbitrary par value as is common stock in some cases that has no bearing on the market value of the shares the common stock and preferred stock accounts are calculated by multiplying the par value by the number of shares issued additional paid in capital or capital surplus represents the amount shareholders have invested in excess of the common or preferred stock accounts which are based on par value rather than market price shareholder equity is not directly related to a company s market capitalization the latter is based on the current price of a stock while paid in capital is the sum of the equity that has been purchased at any price par value is often just a very small amount such as 0 01 importance of a balance sheetregardless of the size of a company or industry in which it operates there are many benefits of reading analyzing and understanding its balance sheet first balance sheets help to determine risk this financial statement lists everything a company owns and all of its debt a company will be able to quickly assess whether it has borrowed too much money whether the assets it owns are not liquid enough or whether it has enough cash on hand to meet current demands balance sheets are also used to secure capital a company usually must provide a balance sheet to a lender in order to secure a business loan a company must also usually provide a balance sheet to private investors when attempting to secure private equity funding in both cases the external party wants to assess the financial health of a company the creditworthiness of the business and whether the company will be able to repay its short term debts managers can opt to use financial ratios to measure the liquidity profitability solvency and cadence turnover of a company using financial ratios and some financial ratios need numbers taken from the balance sheet when analyzed over time or comparatively against competing companies managers can better understand ways to improve the financial health of a company last balance sheets can lure and retain talent employees usually prefer knowing their jobs are secure and that the company they are working for is in good health for public companies that must disclose their balance sheet this requirement gives employees a chance to review how much cash the company has on hand whether the company is making smart decisions when managing debt and whether they feel the company s financial health is in line with what they expect from their employer limitations of a balance sheetalthough the balance sheet is an invaluable piece of information for investors and analysts there are some drawbacks because it is static many financial ratios draw on data included in both the balance sheet and the more dynamic income statement and statement of cash flows to paint a fuller picture of what s going on with a company s business for this reason a balance alone may not paint the full picture of a company s financial health a balance sheet is limited due its narrow scope of timing the financial statement only captures the financial position of a company on a specific day looking at a single balance sheet by itself may make it difficult to extract whether a company is performing well for example imagine a company reports 1 000 000 of cash on hand at the end of the month without context a comparative point knowledge of its previous cash balance and an understanding of industry operating demands knowing how much cash on hand a company has yields limited value different accounting systems and ways of dealing with depreciation and inventories will also change the figures posted to a balance sheet because of this managers have some ability to game the numbers to look more favorable pay attention to the balance sheet s footnotes in order to determine which systems are being used in their accounting and to look out for red flags last a balance sheet is subject to several areas of professional judgement that may materially impact the report for example accounts receivable must be continually assessed for impairment and adjusted to reflect potential uncollectible accounts without knowing which receivables a company is likely to actually receive a company must make estimates and reflect their best guess as part of the balance sheet example of a balance sheetthe image below is an example of a comparative balance sheet of apple inc this balance sheet compares the financial position of the company as of september 2020 to the financial position of the company from the year prior in this example apple s total assets of 323 8 billion is segregated towards the top of the report this asset section is broken into current assets and non current assets and each of these categories is broken into more specific accounts a brief review of apple s assets shows that their cash on hand decreased yet their non current assets increased this balance sheet also reports apple s liabilities and equity each with its own section in the lower half of the report the liabilities section is broken out similarly as the assets section with current liabilities and non current liabilities reporting balances by account the total shareholder s equity section reports common stock value retained earnings and accumulated other comprehensive income apple s total liabilities increased total equity decreased and the combination of the two reconcile to the company s total assets 1