A balance sheet is a snapshot of a business’s financial health at a specific moment in time, usually at the close of an accounting period. A balance sheet comprises assets, liabilities, and stockholders’ equity/capital. Assets and liabilities are divided into short-term and long-term obligations. On a balance sheet, assets should equal liabilities plus owners’ equity.
Assets: Current assets are those that can be converted to cash in one year or less. Common current assets include cash, account receivables, inventory (products manufactured or even work in progress held for sale in the normal course of business), prepaid expenses, and investment securities. Long-term assets are assets that companies retain for an extended time, such as land, plant, and machinery. Long-term assets earn income and/or are held to manage the companies in which the investment is made. Intangible assets also come under the broad category of long-term assets. Intangible assets are those that have no physical or tangible characteristics, for example patents, trademarks, copyrights, and goodwill.
Liabilities: Current liabilities are debts to outsiders that should be paid within one year. Some common items that fall into this category are accounts payable and accrued liabilities, such as salaries and wages that have been incurred but not yet paid. Long-term liabilities are obligations that do not have to be met within one year. These might include long-term notes, bonds, and mortgages.
Stockholders’ equity/capital: The difference between the assets and the liabilities is referred to as stockholders’ equity. Equity is the amount of capital that would remain once the liabilities were satisfied.
- A balance sheet helps managers to decide if the business is in a position to expand, if it can easily handle the normal financial ebbs and flows of revenues and expenses, or if it should take immediate steps to boost cash reserves.
- Balance sheets can identify and analyze trends, particularly in the area of receivables and payables. Is the receivables cycle lengthening? Can receivables be collected more aggressively? Is some debt un-collectable? Has the business been slowing down payables to forestall a cash shortage?
- A balance sheet shows a snapshot of a company’s assets, liabilities and stockholders’ equity at the end of the reporting period. It does not show the flows into and out of the accounts during the period.
- Some numbers depend on judgments, estimates, and interpretation. Intangible assets are factors that might be highly relevant but cannot be reliably measured.
- Financial standards are not always applied to the letter, and balance sheets may not be a true reflection of the financial position of the company.
- Quantify in financial terms how decisions based on the balance sheet could impact on the business.
- Obtain as much information as possible and compare financial ratios before committing to expensive decisions.
- Be prepared to be involved in a long and complicated process of analysis. Some gray areas will not be resolved by financial ratios.
Do’s and Don’ts
- Involve managers and key stakeholders in the company when evaluating balance-sheet findings.
- Determine whether ratios were calculated before or after adjustments were made to the balance sheet. In many cases, these adjustments can significantly affect the ratios.
- Don’t fall into the trap of thinking that financial ratios are infallible when analyzing balance sheets using ratios; use research to confirm results.
- Don’t rely on factors that cannot be reliably measured. Some numbers, such as those for intangible assets, depend on judgments, estimates, and interpretation.See all blog posts