What is a Balance Sheet?
A balance sheet is an important financial statement made by a company, providing a snapshot of its financial situation, including its assets, liabilities, and shareholders’ equity.
🤔 Understanding a balance sheet
Think balanced scale. A balance sheet is a financial equation that’s like a scale perfectly balanced at any point in time. It’s one of the most widely cited financial statements, and shows the value of a company’s total assets (what it owns) as equal to the sum of its liabilities (what it owes, like long-term debt, bills due, etc.) and shareholders’ equity (which is like the “net worth” of shareholders of the company assuming their net worth were tied solely to the particular company being considered). Analysts and investors use the balance sheet to learn more about which funding sources a company uses to support its growth and operations.
Let’s look at a real-world example, the balance sheet of Apple for the fiscal year ending on September 29, 2018: $366B (assets) = $259B (liabilities) + $107B (shareholders’ equity). Apple’s assets include things like its fancy headquarters building in California, its valuable patents, and its huge piles of cash. Its liabilities include monies it owes others. And its shareholders’ equity is the difference between the two.
A balance sheet is like taking a financial portrait of a company with a polaroid camera...
It’s a snapshot, taken at one point in time, that helps capture a company’s health by showing the value of its assets (how much a company owns), liabilities (how much a company owes), and shareholders’ equity (what shareholders’ would theoretically get paid for the shares if the company closed, paid its debts, or sold its assets). In this bread-and-butter financial statement, assets are always equal the sum of liabilities and shareholders’ equity.
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How do you read a balance sheet?
Public companies are required by regulators (like the Securities and Exchange Commission in the US) to file certain financial updates quarterly with the public. Balance sheets are one of those required disclosures. You can typically find them within the quarterly earnings reports that are posted on a company’s investor relations webpage. Private companies, on the other hand, don’t have to publicly disclose their financials. They tend to share their balance sheets only with their board of directors and some of their largest shareholders.
There are three parts to the balance sheet equation, with assets equal to liabilities (how much a company owes) and shareholders equity (essentially, the net worth of the company or the difference between assets and liabilities).
Looking at this statement, you’ll see that assets have the same value as total liabilities plus total shareholder equity. On balance sheets, assets and liabilities are typically listed in order of how easily they can be converted into cash, which in financial lingo, is expressed as how “liquid” they are. Assets are typically organized ranking from most liquid (cash, or easiest to turn into cash) to least liquid (hardest to convert to cash, like land or property), while liabilities tend to be organized from short to long-term obligations.
What tools can help you analyze a balance sheet?
Balance sheets are another place where it can come in very handy to have an investor toolbox, with more ratios.
One example is debt-to-equity ratio: This is calculated by dividing a company’s total liabilities by its shareholder equity (the amount shareholders’ shares would be worth if a company shut down, sold its assets, or paid its debts), and can help investors better understand how a company’s capital structure is tilted either toward debt or equity financing.
Other financial analysis ratios pull information directly from balance sheets. These fall into two main categories:
- Activity ratios: Activity ratios tend to focus on current accounts to show how well a company creates revenues out of its cash and resources, including areas such as inventory, accounts payable (money that’s due or required to be paid), and accounts receivable (money that’s owed to the company).
- Financial strength ratios: This type of ratio reflects how well a company can meet obligations such as paying back creditors (to avoid going bankrupt), and what kind of financial sources are funding the company’s operations. One example of a financial strength ratio is the working capital ratio (or “current ratio”), which is a measure of short-term financial health and liquidity — how easily a company will meet its short term financial obligations with the short-term cash it has.
What are assets?
- Current assets: These are assets that can be converted into cash within a year. Some examples of current assets are cash and items equivalent to cash (aka “cash equivalents,” such as checks), amounts owed to a company within the next 12 months (for example, payments owed to a company by customers), and inventory (which is materials or final products sitting on in the warehouse).
- Non-current assets: Non-current assets are tougher to convert into cash. They include things that require over a year to become cash, such as plant, property, and equipment (which isn’t easy to sell), as well as any other payments to the company that are due more than one year from now. Non-current assets can also be intangible, meaning their value isn’t tied into a physical property, such as patents or copyright, or a company’s brand. Physical assets such as equipment undergo what’s known as depreciation, while intangible assets are usually amortized. It’s what happens as soon as you drive your brand new convertible out of the dealership parking lot — depreciation, aka, its value drops. In more technical terms, depreciation represents the monetary cost of an asset over its functional life.
What are liabilities?
Liabilities are what a company owes to outside parties, and they can be long or short-term liabilities.
- Current liabilities: This refers to amounts owed that must be paid within one year, which could include debt like short-term borrowing or accounts payable (for example, what the company owes a third party consulting firm it hired to do work).
- Long-term liabilities: These are debts and non-debt obligations that are due at least one year from the date of the balance sheet.
What is shareholders’ equity?
In the balance sheet equation, shareholders’ equity is equal to the difference between total assets (what a company owns) and total liabilities (what a company owes). Another way of thinking about shareholders’ equity is that it represents what the net worth of shareholders’ would be, if their net worth were tied solely to the particular company being considered.
Shareholders’ equity is not the same as the real-time value of the shareholders’ stock, based on the stock price. It’s often a more conservative calculation, based on the book value of a company’s assets and liabilities. Market value is different, it’s based on investors’ perceptions of value, which is more volatile. Shareholders’ equity calculates what shareholders’ stakes would be worth if the company were to shut down — what would be left-over when the company pays all its debts and sells all its assets. That’s shareholders’ equity.
Why are balance sheets helpful?
Balance sheets are one part of the trifecta of financial statements that can offer key insights into how a company supports its expenses, and how efficiently (or inefficiently) it runs. It’s a snapshot that can be taken at any point in time. The other two key financial statements are the income statement and cash flow statement, which highlight other elements of a company’s financial status. Balance sheets can help investors quickly understand a company’s financial well-being, and they’re useful to creditors and lenders, too. The equation can help lenders (such as a bank) determine if they should extend credit to a business, or if they should reel in their existing credit to that company.
What can't a balance sheet do?
While balance sheets can be very helpful, they have their caveats. Here are a few:
- Historical transactions: Even though balance sheets are a snapshot of a company, they still only reflect financial events, such as assets acquired in the past, that have already happened. As a result, they’re not predictive in and of themselves. Although, they can be used by analysts and investors as helpful information that can help shed light on the potential trajectory of a company.
- Limited asset inclusion: Assets are one side of the balance sheet equation. However, it’s important to note that only assets that a company acquired in a transaction get incorporated into the asset calculation. Goodwill gets reported in the balance sheet, some of which are intangible assets. This could include the value of a company's brand or its proprietary technology — the downside is that the value of these intangible assets can't be precisely quantified.
- Asset appreciation: When it comes to long-term assets that were acquired through a transaction, such as land or real estate, the value of the long-term asset that gets used on the balance sheet is the transaction price minus accumulated depreciation. How the item is reflected as an expense over a financial period, such as a year, over the timespan that asset is used. Depreciation expense for a $10,000 smoothie machine that lasts for 10 years, for example, could appear as having a $1,000 cost to the company each year, for 10 years, even if the property or land may have increased in market value over time. As a result, a company’s land and buildings could have a much different market value than what is reflected in the balance sheet equation. This is accounted for when assets are sold, and they’re called “gains or losses from asset sales.”
We like how the SEC has more helpful material on financial statements like the balance sheet that you can check out here.
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