A balance sheet (or statement of financial position) is a financial report that summarizes an organization’s assets, liabilities, and shareholders’ equity for a particular period of time. What this means is that the balance sheet provides a picture regarding what the organization owes and owns for a particular time frame. This is important as the balance sheet report reflects the organization’s status and can give you an indication of its financial stance.
The assets portion of the balance sheet goes into what the business owns that can be converted to cash. Assets on the balance sheet are listed in order of liquidity- those that can be converted to cash quicker will appear first. Assets can further be broken down into sub-categories such as current assets and long-term assets.
Current assets are assets that can be converted to cash in up to one year. This can further be broken down into cash, investments that can be sold in less than one year, accounts receivable (money owed by clients), and inventory.
Long-term assets are assets that require more than a year to get their money’s worth. This can come in the form of buildings, equipment, property, and intangible assets such as copyrights or patents.
Liabilities refer to money that is owed to others, for example loans. Like assets, this category can be broken into the subcategories of current liabilities (such as utilities, taxes, and payroll) and long-term liabilities.
Shareholder’s equity refers to the sum of money that is generated by a business and how much is put into the business by shareholders. Another way to think about shareholder’s equity is as net assets, as the formula for calculating shareholder’s equity on a balance sheet is:
Shareholder’s equity= Assets- Liabilities
Here’s a balance sheet sample:
Balance sheet analysis example
Let’s take a look at our balance sheet example. As you can see, the total assets on the left side amount to $770,000. This sum is equivalent to the right side that represents liabilities and stockholder’s equity. This side also amounts to $770,000. Meaning, the balance sheet is balanced. Notice that both the assets and liabilities columns are divided into short term and longer term, and list out in descending order from those with highest to lowest liquidity. A balance sheet analysis can provide you with lots of information regarding how the organization is doing.
Another way to examine the balance sheet report is by conducting a vertical analysis of the balance sheet. Vertical analysis is a method of looking at the financial statement by looking at each line as a percentage of some predetermined base figure from the statement. For example, the vertical analysis can look at a particular line item on the balance sheet as a percentage of total assets.
The balance sheet is one of three essential statements.
While the balance sheet report reflects assets, liabilities, and shareholder’s equity, it is one of three essential financial reports that, when taken in together, provide a holistic picture of the financial health of an organization. The other two statements are the P&L and the cash flow statement.
How do you evaluate a company’s balance sheet?
Generally speaking, one can measure the strength of a company’s balance sheet by looking at three broad categories of investment-quality measurements: working capital, asset performance, and capitalization structure.
Working capital refers to the difference between an organization’s current assets (ex. Cash, investments, AR) and current liabilities (ex. payables owed to suppliers). Working capital is an indication of an organization’s cash conversion cycle, an indication of how well a company can manage two very important assets- accounts receivable and inventory.
Asset performance refers to the ability to take operational resources, manage them, and produce profitable returns. The return on assets (ROA) ratio serves as a metric for determining the asset performance of an organization.
Finally, capitalization structure refers to the amount of debt compared to equity that a company has on its balance sheet.
What does the balance sheet tell me?
The balance sheet is a very telling document. It reveals:
- The company’s degree of liquidity- does the organization have enough cash or liquid assets to pay obligations?
- The nature of the business- what are the risks involved? Are the accounting principles and methods appropriate, conservative, or aggressive compared to others in its industry? Are judgments about the selection and method of application of accounting principles based on substance, rather than form?
- The use of historical cost or fair value measurement methods-How great a difference is there between the amounts resulting from the historical cost and fair value methods? To what extent have acquisitions caused a larger portion of the balance sheet to be stated at fair value?
- The estimates and assumptions used in the financial statements- Are the estimates and assumptions reasonable and supportable? Are they determined consistently? Do reserves based on management estimates represent a significant portion of liability or asset valuations?
- The possibility of impairment- Are the company’s policies for evaluating impairment reasonable? Do any economic, performance, or industry trends raise questions regarding the ability to recover assets at their recorded amounts?
How can the balance sheet be used?
There are a few ways to look at the balance sheet. But no matter how you spin it, the goal is to provide an understanding of the company’s financial position at any point in time.
Who takes an interest in the balance sheet? Well, people who are likely to review this document include internal stakeholders like shareholders or management, external stakeholders such as investors or banks, and potential new stakeholders like lenders or buyers.
The balance sheet can be a very telling piece of information. For example, by looking into the balance sheet, managers can decipher whether they can afford new investments in things such as property or more staff. It can also help prevent further financial problems by bringing to light when it might be time to reduce existing debt or transform particular assets into cash.
For outsiders, the balance sheet can be telling as well. External stakeholders may be interested in getting a picture of how the company has performed over time. By applying financial ratios to the balance sheet, potential investors or buyers can figure out things like how much of a credit risk the organization represents, how much money the can allow themselves to borrow, how likely is it to provide a return on investment, and how much potential there is for growth.
Why should I thoroughly examine the balance sheet?
The balance sheet provides data that can be used to calculate basic financial ratios. Financial ratios can be used to track the performance of an organization and identify trends. Thanks to balance sheet data, organizations can assess factors including the ability to meet financial obligations and how well they can use credit to finance operations.
The balance sheet represents a particular point in time, but most balance sheets often include data from previous years to allow for comparisons about how the business is performing over time.
Data from the balance sheet can also be combined with data extracted from other financial statements. This can provide you with an even better understanding of organizational finances.
The Future of Reporting
To take balance sheet reporting up a notch, cloud FP&A platforms such as DataRails can assist with creating automated financial reports. And the best part? You don’t have to change the way you work to improve your processes. DataRails is an Excel-based solution, which means that you can leverage your existing spreadsheets, models, and intellectual property that is built into your Excel spreadsheets. Keep using the interface you are familiar with while simultaneously boosting your capabilities. Automate your balance sheet template without changing how you work. DataRails fits itself to you, not the other way around.