Understanding a company’s financials is essential to being able to make informed decisions, forecast as accurately as possible, measure business performance, and avoid investment mistakes. One of the most important financial documents for any business is the balance sheet. This allows business owners, financial advisors, and investors to reflect on the period and plan for the next phase to avoid major pitfalls or even running your company into bankruptcy.
The balance sheet provides an overview of a company’s current net worth. Balance sheets are created at the end of each accounting period, which could be monthly, quarterly, or annually.
While the balance sheet is only one piece of a business’s financial puzzle, it is essential that you have a general understanding of what it is, what it includes, and how to read it—however, that’s typically easier said than done for those who aren’t familiar with it. We’ll cover all these aspects and more in this post. For a comprehensive overview of balance sheet statements, we recommend reading straight through. For a more direct answer to your question, use the links below.
- What Is a Balance Sheet?
- What’s on a Balance Sheet?
- Balancing a Balance Sheet
- Limitations of Balance Sheets
- Applying Your Newfound Balance Sheet Knowledge
What Is a Balance Sheet?
A balance sheet is one of the three main financial statements (income statement, statement of cash flows, and balance sheet) which are used to make business decisions both internally and externally (when investors are considering your company).
Balance sheet definition:
The balance sheet is used to report a business’s total assets, liabilities, and shareholders’ equity. In the most general of terms, the balance sheet shows a rundown of what a business owes and owns.
For a basic overview of the other types of financial statements, visit SEC.gov.
The balance sheet can help you answer important questions about the business, including:
- What is the capital structure of the business?
- Does the company have enough liquidity to repay current liabilities?
- Is the company overrun with debt?
- How much money is currently owed to the company?
- Is fast or slow is inventory moving?
- How long is taking to get paid by customers?
- Is investing in this company likely to be high risk? (Read up on our article about fundamental volatility)
What’s on a Balance Sheet?
There are three categories that are included on the balance sheet:
- Assets: What the company owns. This can include cash and inventory. While property is also considered an asset, equipment is classified as a long-term asset because it’s value and useful life depreciates over time.
- Liabilities: How much the company owes. This can be anything from rent and utilities to loans.
- Shareholders’ Equity: This is how much is invested in the company, or how much of business is owned by investors, and the retained earnings (those that are not paid out to stockholders as dividends) that would be left over if all assets were liquidated and debts were paid.
- For sole proprietorships, this is known as owner’s equity and accounts for the amount of money you’ve directly invested.
Let’s take a closer look at each of these key facets of the balance sheet:
Assets are anything that the company has ownership or control over, even if it’s not technically in their financial control just yet (think accounts receivable). When looking at assets, here are a few key things to keep in mind:
- Assets are listed at the top or on the left hand side of the balance sheet (if it’s divided into two columns).
- The order of assets matters. Starting from the top, assets are listed in order of liquidity, meaning the assets that can be most easily converted to cash (should the company need to), are listed first.
- Assets are put into two general categories; current and long-term assets. The distinction is that current assets, like inventory, are turned into cash in a year or less.
Liabilities comprise everything the company currently owes on (loans, credit lines, accounts payable). To better understand the liabilities section of the balance sheet, keep these considerations in mind:
- Liabilities are listed below assets or on the right hand side of the balance sheet (if it’s divided into two columns). You will find a full list of current liabilities above the Shareholders’ Equity section.
- Liabilities are not a negative reflection of the company. Liabilities are necessary to keep a company running. The problem is when liabilities far outweigh assets or a business continuously has higher liabilities than their assets.
- Liabilities are broken down into two major categories. First are the current liabilities, debts that have to be paid within 12 months. These include 12 months of debt service on longer-term notes as well as accounts and taxes payable. Second are long-term liabilities, the obligations of the company beyond the next 12 months. These accounts include long-term debts and bonds issued.
Shareholders’ Equity (or Owner’s Equity)
Shareholders’ equity is the remaining amount of assets owned by the owner or shareholders once all debts are accounted for. When reviewing shareholders’ equity on the balance sheet, there are a few things you should keep in mind:
- Shareholders’ equity is listed after liabilities on the balance sheet (it may also be on the right side of the balance sheet if it’s divided into two columns). You will find a list of current shareholders’ equity at the bottom of the balance sheet.
- Investors see negative shareholders’ equity as a sign of poor financial health. A positive shareholders’ equity means that the company has enough assets to pay its liabilities.
- Shareholders’ equity can be used to evaluate how well a company is using its investors’ funds. This is done by using the Return on Equity (ROE) ratio, which divides net income by shareholders’ equity.
Let’s take a look at a balance sheet example, so you can see how these aspects actually look on the balance sheet:
As you can see, the labeling makes it pretty clear what’s what. Now let’s move on to how you see if your balance sheet is completed correctly by exploring how you balance a balance sheet.
For another balance sheet example that you can inspect more closely, review the September 2018-2019 financial statements of the U.S. government by visiting fiscal.treasury.gov.
Balancing a Balance Sheet
If you’re someone who shudders at the thought of crunching numbers, you might automatically assume that balancing a balance sheet is going to be a major headache. However, the equation is fairly straightforward:
The most important thing to keep in mind is that each side of this equation must be equal to the other.
How is that possible? Assets should equal the sum of liabilities and shareholders’ equity because assets are either owned outright by you or funded by your investors (owner’s or shareholders’ equity), or they have been purchased using a loan or credit (liabilities).
Because this equation should always be balanced, it should also hold true that:
Shareholders’ Equity = Assets – Liabilities
So, how do you actually put this into practice? Let’s dive a little deeper with a real-world example.
Say that your company has $100,000 in assets, $45,000 in liabilities, and $55,000 in shareholders’ equity.
- Assets = Liabilities + Shareholders’ Equity: $100,000 = $45,000 + $55,000
- Shareholders’ Equity = Assets – Liabilities: $55,000 = $100,000 – $45,000
That’s an example of how this equation works both ways. Now, let’s see how taking out a loan would affect the three components of the balance sheet.
Say you took a $5,000 loan out from the bank. This is how the equation would change (still working with the previous numbers as a starting point).
A loan will increase both your assets (because you now have this additional $5,000 to put towards operations) and liabilities (because a bank loan is considered a long-term liability).
Assets: $100,000 + $5,000 = $105,000
Liabilities: $45,000 + $5,000 = $50,000
Shareholders’ equity: Remains the same
How does shareholders’ equity remain the same? Plug the numbers into the equation that’s used to calculate shareholders’ equity:
Shareholders’ equity = $105,000 (assets) – $50,000 (liabilities)
Shareholders’ equity = $55,000
As you can see, balancing a balance sheet is fairly straightforward now that you know how the different pieces of the equation are interrelated.
While you can gather valuable information by reviewing your balance sheet at the end of each period, it’s not enough to simply look at the balance sheet.
Limitations of Balance Sheets
As mentioned earlier, the balance sheet was never intended to give the whole story. Instead, you should be referring to all of the financial statements to get an overall picture of the company’s finances and draw conclusions based on the bigger picture. Additionally, investors will need more information when they’re considering whether to put money into your company.
The problem is that you can’t get the full financial picture from a balance sheet because both assets and liabilities can give you a misleading picture of a company’s true worth. For example:
- Assets can sometimes be valued far below their true value.
The accounting rules require that capital assets (buildings, machinery, autos and trucks) are listed at their purchase price, minus depreciation. The resulting “net” asset is the value carried on the balance sheet no matter what true market value is at the time.
A company may own a building it purchased 30 years ago for $2 million, including $500,000 for the land and $1.5 million for the building itself. Today, the property is worth $30 million. However, the value of the building has been depreciated from $1.5 million down to zero (the value of land stays on the books at $500,000 and is not depreciated). So in this case, a property with market value of $30 million is carried at only $500,000, or 1/60th of its true value.
- Depreciation may not be accounted for.
This can work in the other direction as well. Companies might pay for assets that have become obsolete or lost value, but this is never adjusted on the balance sheet. The original cost, minus depreciation, is the basis for all capital assets, no matter how their actual value has moved.
- The balance sheet also doesn’t show contingent liabilities and contractual agreements in the list of liabilities.
A contingent liability is a possible debt that has not yet been realized but could come to pass in the future. So if a lawsuit has been filed against a company seeking $80 million in damages, it is not a liability. But if the case is won by the plaintiffs, it becomes a liability. This contingency is not included on the balance sheet, but is disclosed in the footnotes.
A contractual agreement may include leases on autos and trucks, or even very long-term leases on occupied buildings and warehouses. Even though these obligations can run into the millions, they do not show up under current or long-term liabilities. You have to search through the footnotes to find them. They are very real obligations, but under the accounting rules they are simply not listed on the balance sheet.
To avoid these common pitfalls, you will want to review the footnotes in the annual report, which should disclose the differences between net book value and true market value of capital assets; it should also explain how other assets may be valued either above or below true market value.
It’s important to also keep in mind that numbers don’t tell the full story of how to successfully manage a business. You must also take into account consumer behavior—specifically when it comes to your target audience—the current economy, and overall goals.
Applying Your Newfound Balance Sheet Knowledge
Now that you have a better understanding of how to read and use a balance sheet, instead of a point of frustration, it can be a useful tool for making business decisions. Whether you are looking to improve the financial health of your own business or are perhaps considering expanding by investing in another company, you now have one more piece of the financial puzzle.