Understanding balance sheets as essential financial tools for business analysis

A balance sheet is a financial statement that shows a company's assets, liabilities, and shareholders' equity on a specified date. It is used to assess a company's financial health and is also referred to as a "statement of financial position." Businesses utilize a variety of accounting tools, including a balance sheet, to determine where they stand financially at a given time. Balance sheets are not intended to reflect earnings in the same manner as profit and loss statements (P&L) do. Instead, balance sheets are designed to balance out, often by following the accounting equation: Assets = Liabilities + Shareholder Equity.

"I prefer to convey to customers that the profit and loss statement is a movie and the balance sheet is a photograph. The profit and loss statement illustrates income and expenses over time, whereas the balance sheet depicts the company's financial situation at a certain point in time," explains Courtney Barbee, owner and COO of The Bookkeeper. For example, a profit and loss statement may reflect profits and expenses over the fourth quarter, whereas a balance sheet covers what the company owns and owes on the last day of the quarter.

In recent years, the importance of balance sheets has grown significantly, particularly in light of economic uncertainties and market volatility. Investors and analysts are increasingly scrutinizing balance sheets to gauge a company's resilience and ability to weather financial storms. This heightened focus has led many companies to prioritize maintaining strong balance sheets, often by reducing debt levels and increasing cash reserves. As a result, balance sheet management has become a critical aspect of corporate strategy, influencing decisions on capital allocation, dividend policies, and mergers and acquisitions.

Balance Sheet Components

As previously stated, a balance sheet consists of three major components that are intended to balance. Companies typically utilize the equation: Assets = Liabilities + Shareholders' Equity; however, you can reorder this equation in different ways, such as Liabilities = Assets - Shareholders' Equity. The outcome should still be an equal balance on both sides of the equation; you are simply rearranging the calculations. Here's what these components include:

Assets

The first section of a balance sheet typically shows the value of what a company owns. "The top portion consists of assets, which are tangible or intangible items of value owned by the corporation. These could include cash, accounts receivable, equipment, or even items like a trademark or prepaid expenses." These assets are often classified as current or non-current assets and listed in order of liquidity. Current assets include cash and cash equivalents, accounts receivable, inventories, and anything else of value that is expected to be converted to cash within a year. Non-current assets include valuable assets like as equipment, investments, copyrights, and intellectual property that are not expected to be converted to cash within a year.

The classification and valuation of assets on a balance sheet can have significant implications for a company's financial reporting and tax obligations. For instance, the treatment of intangible assets, such as intellectual property or goodwill, can be particularly complex. Companies must carefully consider how they value these assets, as overvaluation can lead to inflated balance sheets and potential write-downs in the future. Conversely, undervaluation may result in missed opportunities for leveraging these assets for financing or strategic partnerships. As such, the asset section of a balance sheet often requires careful scrutiny and expert analysis to fully understand its implications for a company's overall financial health.

Liabilities

A balance sheet normally includes a liabilities section following the assets section. This includes money payable for debts and bills. This also comprises current and non-current liabilities, which are separated similarly to current and non-current assets. Current liabilities include accounts payable, accrued expenses, and debt obligations due within a year. Non-current liabilities are long-term expenses, such as long-term bonds issued by the corporation and deferred tax liabilities, that are scheduled to be paid more than a year from now.

Shareholder Equity

Shareholders' equity, often known as owner's equity depending on the company structure, is the amount of a firm's assets that its shareholders or owners claim. This equity frequently comprises components such as the amount of money shareholders have invested in the firm as well as retained earnings, which are profits maintained by the company. The term shareholders' equity can also refer to net assets, which are total liabilities minus total assets.

The concept of shareholders' equity has evolved in recent years, particularly with the rise of alternative corporate structures and financial instruments. For example, the growing popularity of Special Purpose Acquisition Companies (SPACs) and the increasing use of convertible securities have introduced new complexities to the equity section of balance sheets. These developments have prompted discussions among accounting standard-setters and regulators about how to best represent these new forms of equity on balance sheets. As a result, investors and analysts must stay informed about these changes to accurately interpret the equity portion of a company's balance sheet and its implications for shareholder value.

Reading a Balance Sheet

When it comes to balance sheet presentation, you can choose between a vertical balance sheet, like the one shown below, in which things are placed in a column that is read vertically or up and down. There is also the option of using a horizontal presentation, in which assets, liabilities, and equity are read horizontally. In this scenario, liabilities and shareholder equity are presented on the right side, while assets are listed on the left. Vertical presentations are more common.

"On the balance sheet, assets are listed in order of how easily they can be converted into cash. Liabilities are mentioned in the order of when the required payment is due and payable," explains Phil Weiss, CFA, CPA, and principal at Apprise Wealth Management. "Beneath the assets are the liabilities, or what the corporations owe. According to Barbee, this includes unearned revenue as well as debts like loans and credit cards. The shareholders' equity is paired with their liabilities. All of the profit and loss statement up to the balance sheet date is really held in this part as retained earnings." The balance sheet equity line may contain more than meets the eye and is an important statistic for investors to consider. "It also includes equity that has entered through cash infusions or stock sales, as well as equity that has exited through distributions." Barbee argues that the balance sheet is created by combining the liabilities and shareholders' equity to equal the assets.

Example of a Balance Sheet

As an investor, you can access essential financial documents from publicly traded corporations via the Securities and Exchange Commission (SEC). Here's an example of an Apple balance sheet, on page 3. As you can see, assets are divided into two categories: current assets, including their subcategories, and non-current assets, including their subcategories. Current and non-current obligations are listed below, along with their respective subdivisions. At the bottom, you can see the shareholders' equity.

How is a balance sheet used?

Balance sheets are useful for measuring a company's financial health and performance. Balance sheets, whether utilized by a major publicly traded firm or a small business, can provide crucial information about a company's assets and liabilities. A balance sheet is particularly useful for:

Financial analysis. A balance sheet can be used to evaluate a company's financial position in a variety of ways. For starters, comparing liabilities to assets might reveal whether the organization is overburdened with debt. Looking deeper, at variables such as current assets vs. current liabilities,... you can determine whether a company has sufficient liquidity to satisfy its short-term debt obligations. Similarly, you can examine long-term solvency by determining if the organization has the assets required to meet long-term debt obligations. Looking at shareholders' equity in relation to these other components offers important financial insights, such as a firm's ability to retain earnings and maintain a strong base of invested capital, which may indicate that the company does not need to rely on debt as much.

Ratio analysis. A balance sheet contains crucial information that can be utilized to compute certain ratios for financial analysis. For example, when calculating a firm's debt-to-equity ratio by dividing liabilities by shareholders' equity, a high figure indicates that the company may have an unhealthy reliance on debt, whereas a low number shows that it has a strong investment foundation. The shareholder's equity section of a balance sheet can be combined with the earnings portion of an income statement. When earnings are divided by equity, you get a return on equity (ROE) value, with a high one indicating that investors' capital is being put to good use to generate considerable earnings, and a low one indicating that the investments are not yielding much profit.

Comparison and Trend Analysis

While balance sheets provide a snapshot of financial data, analyzing balance sheets over time can reveal trends, such as whether a company is getting a better grasp on its debt. Comparing balance sheets of industry peers can also be useful when deciding which investment to make.

Pros and Cons of Using a Balance Sheet

A balance sheet is one of the most important financial statements for organizations to utilize when reviewing their finances. Investors can also study the balance sheets of publicly traded corporations to determine their profitability. It is critical to grasp both the benefits and limitations of analyzing a balance sheet.

Importance of the Balance Sheet

Balance sheets can be significant for various stakeholders, including:

Investors

Before investing in a firm, investors might review its assets and liabilities and calculate indicators such as ROE. "Investors look at balance sheets to help assess a company's financial viability," Weiss explains. When determining whether a company is adequately valued, market value is often compared to book value. Book value is essentially the value of a firm based on its balance sheet. Book value is calculated by subtracting a company's total assets from its total liabilities. The market value of a corporation is calculated by multiplying its share price by the number of shares issued. A stock is deemed undervalued if its market value is significantly lower than its book value, indicating that it is selling for less than the value of the company's net assets. However, because balance sheets are snapshots, this is not always the case, as market valuations may reflect investors' future expectations. For example, fast-growing businesses frequently have higher market values than book values. This is due to investors' optimism about future revenue and total valuation growth, as well as the fact that certain companies have greater earnings power, or profit-generating ability, than present assets. In some circumstances, however, a higher market than book value may suggest that the item is overvalued.

Creditors

A balance sheet is also essential for creditors who wish to determine a company's ability to repay debts before issuing fresh loans. For example, if the company has little liquidity, as indicated by current assets practically matching current liabilities, a creditor may be cautious to lend short-term funds. To avoid risk, they may instead offer long-term debt at a higher interest rate or require collateral.

Management

A company's management team can utilize balance sheets not just to inform investors and creditors, but also to make more informed decisions about how to run the business. For example, a corporation considering investing in new assets such as buildings or machines may compare its assets and liabilities to determine whether now is an appropriate time to make those new investments.