A balance sheet is a financial statement that shows you three things about a company:
- Assets: How much the company owns
- Liabilities: How much the company owes
- Shareholder equity: What’s left when you subtract liabilities from assets
A balance sheet only shows you a company’s financial status at one point in time. If you want to know how a company’s assets and liabilities have changed over time, you will need to have historical balance sheets to compare.
Analyzing Assets on a Balance Sheet
An asset is anything of value the company has. This includes cash, investments and tangible objects. Companies divide their assets into two categories: current assets and long-term assets.
Current assets are things that the company can convert into cash within one year. This includes cash, investments like stocks or bonds, prepaid expenses and physical inventory. A balance sheet will break down the value of each type of current asset.
Long-term assets are tangible assets that the company uses over the long term. Examples are property, buildings, furniture, vehicles, equipment, and machinery, as well at intangible assets such as patents, copyrights, and goodwill. Note that some companies refer to these as “noncurrent assets” or “fixed assets.”
Analyzing Liabilities on a Balance Sheet
Liabilities are any money that a business owes. They cover bills for supplies, rent, utilities, company salaries, loans or deferred taxes. Just like assets, there are two types of liabilities: current liabilities, which a company owes within the next year, and long-term liabilities, which the company must pay anytime beyond one year from now.
Current liabilities include any money that the company owes to other parties in the short term (one year or less), such as accounts payable, credit card payable, taxes payable, accruals, unearned revenue, interest payable and the current portion of long-term debt.
If a company borrows money but doesn’t have to pay it back in the short term, it’s accounted for here.
Bonds payable include any bond that the company has issued. The value here is the amortized amount of the bond. Amortization is the process of taking an expense and expanding its cost over the life of the expense.
Analyzing Shareholder Equity on a Balance Sheet
Shareholders’ equity is the money that goes to a company’s owners or shareholders. You can calculate it simply by subtracting liabilities from total assets. That means shareholders’ equity is also the company’s net income, net worth and overall value.
Shareholders’ equity tells you how much a company has left after covering its liabilities. If it wanted to, the company could then pay out all of that money to its shareholders. This happens in the form of dividends. However, it’s more likely that the company reinvests the money into the company. The money that the company keeps is its retained earnings. Even if a company does pay dividends to shareholders, it may still retain some money.
This is the value of what investors have invested in the company. For example, let’s say you start a company and someone invests $100,000 to help you start your company. On a balance sheet, you would count that $100,000 with your cash assets and you would also count it as part of your share capital.
You may also see lines in the shareholders’ equity section for stock. Common stock is what most people get when they buy stock through the stock market. Preferred stock entitles the shareholder to a greater claim on the company’s assets and earnings.
What Are the Benefits of Looking at a Balance Sheet?
Investors and lenders can also use the numbers from a balance sheet in some useful financial equations that help analyze the value of a company. Here are a few:
- Working capital = current assets – current liabilities
This is the capital a company has to use in its day-to-day trading operations.
- Debt-to-equity ratio = total liabilities ÷ shareholders’ equity
This tells you how much of a company’s financing comes from investors versus creditors. Investors generally consider companies with higher ratios (that is, with more financing from debt) as riskier investments. Unlike equity, a company needs to pay back all of the debt that it owes. So the more debt a company has, the more it has to make just to pay back that debt. Companies with lower debt to equity ratios are seen as more stable. You may also see the term debt/equity ratio or the abbreviation D/E ratio.
- Quick ratio = (cash and equivalents + marketable securities + accounts receivable) ÷ current liabilities
Also known as the acid-test or the liquidity ratio, this is a measurement of a company’s ability to cover its short-term liabilities. A ratio greater than one indicates that the company has enough in cash and cash equivalents to pay its obligations and cover its operations.
- The balance sheet can also tell you things like the length of your accounts receivable or inventory turnover cycle (i.e. the number of times they turn over each year).
An understanding of the balance sheet enables an investor or lender to evaluate the liquidity, solvency, and overall financial position of a company. The concept of liquidity relates to a company’s ability to pay for its near-term operating needs.
Preparing timely and accurate balance sheet for your business along with income statements (profit & loss statements) and statements of cash flows will give you, along with any relevant stakeholders the information to determine the health of your business and the information needed to make really good business decisions.
To learn more or for customized support for your business call Moore Norman Technology Center Business & Industry Coordinator Henry Dumas at 405-801-3540.