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Understanding the Balance Sheet
Balance Sheet Photo

Many people may have financial statements or a balance sheet in front of them, but they do not know what they should be looking for. The financial statements can be seen as a maze as there is so much information and people do not know where to start looking first. 

While the balance sheet report reflects assets, liabilities, and shareholder’s equity, it is one of three essential financial reports that, when taken in together, provide a holistic picture of the financial health of an organization. The other two statements are the Income Statement and the cash flow statement. 

The balance sheet provides insights on what the business owns (its assets), what the business owes (its liabilities), and how much the business is worth for a particular period of time. It helps you spot the strengths and weaknesses in your business, helping you make smart decisions about how to invest and grow in the future.

In a balance sheet, there are three main components with sub-components listed in order of liquidity:  

Assets

Assets are what the company owns and uses for its operations. It includes tangible and intangible assets. The assets of a company can be divided in two sub-categories:

Current Assets are assets that can be converted into cash within a period of one year or less.  

  1. Cash and cash equivalents — includes most liquid assets of the company
  2. Receivable accounts — money the customers still owe to the company
  3. Marketable securities — all equity as well as debt investments that have a liquid market
  4. Inventory — goods the business currently has in stock ready to sell listed with the current market price or lower
  5. Prepaid expenses — value that has been paid for expenses such as insurance or rent

Non-Current Assets are assets that cannot be converted within a period of one year.

  1. Any long-term investments — investments that cannot be liquidated in the coming year
  2. Fixed assets — assets such as land, machinery, equipment, and buildings.
  3. Intangible assets — assets that are not physical assets but have value. Intellectual property, for example, is an intangible asset. Intangible assets like this are only listed on a balance sheet if the business acquires them.

Liabilities

Liabilities are what the company owes and need to pay to complete their obligations. The liabilities of a company can be divided in two sub-categories:

Current Liabilities are obligations that needs to be fulfilled within a year.

  1. Accounts payable — amounts due to ven­dors that have supplied goods or services
  2. Deferred revenues — amounts a customer has prepaid and will be earned by the company within one year of the balance sheet date
  3. Accrued compensation — payroll due to employees and to be remitted for payroll taxes
  4. Other accrued expenses — amounts owed for items not recorded in accounts payable or accrued compensation
  5. Accrued income taxes and some de­ferred income taxes
  6. Short-term notes — loans from banks that will become due within one year
  7. Current portion of long-term debt — principal payments of a mortgage loan or an equipment loan that must be paid within one year
  8. Dividends payable to investors or shareholders

Non-Current Liabilities are obligations that needs to be fulfilled after one year.

  1. Long-term debt — loans incurred
  2. Pension fund liability — payments for employees’ retirement funds
  3. Deferred tax liability — tax payments that will not be payable for the next year or later

Owner Equity

This refers to the sum of money that is generated by a business and how much is put into the business by shareholders. The equity section is commonly divided into the following sections:

  1. Capital stock (original)
  2. Retained earnings — net earnings the business uses to pay off its debt or re­invest in the business. The remaining is then distributed to owners as distributions or shareholders as dividends.
  3. Treasury stock — stock that the company has either repurchased or never issued. It can be used to raise cash or prevent a hostile takeover, or it can be sold.
  4. Additional paid-in capital — common stock or preferred stock in which shareholders have invested. The value is based on par value instead of a market price.

The golden rule of a balance sheet is that at the end, the following equation must balance:

Balance Sheet Examples

The following two examples will help you understand the basics. The key is to always be in balance!

Balance Sheet Example 1:

Brian, the owner of the above company decides he wants to finance a brand new $45,000 SUV. Because the car is valued at $45,000, we will add this amount to the asset side under the account “Vehicles” and add the outstanding debt to the liabilities side, as seen below.

Assets vs Liabilities
Balance Sheet Example 2:

Let’s say Brian wants to pay off his credit card balance. He will need to pull the funds from his cash account. Because the credit card balance is at $5,250 both the cash and credit card accounts are reduced by this amount. Notice that even though Brian’s cash levels decreased by over $5,000, the owner’s equity value of the business didn’t change. The payment simply decreased funds from the asset side (cash) to pay off a liability (the credit card) with no effect to the amount of equity Phil had in the business.

Cash & Credit Cards

Understanding these basics are foundational to interpreting what the numbers mean. There are some simple financial ratios that can be used to gain a deeper understanding of the balance sheet. The most common include the following:

  • Debt-to-equity ratio = total liabilities / shareholders’ equity – reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.
  • Working capital = current assets – current liabilities – Working capital is a measure of a company’s liquidity, operational efficiency, and short-term financial health. If a company has substantial positive working capital, then it should have the potential to invest and grow.
  • Quick ratio = (current assets – inventory) / current liabilities – The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.
  • Debt to total assets = total debt / total assets – The debt to total assets ratio is an indicator of a company’s financial leverage. It tells you the percentage of a company’s total assets that were financed by creditors.

The Bottom Line

The balance sheet provides an idea of the company’s financial position, indicates whether the business is profitable and helps to determine what actions, if any, need to be taken to improve the company’s performance. When used in conjunction with the other financial statements it enables business owners, investors and bankers to gather an understanding of the overall health of the company. If you are looking to take your business to the next level Apex CPAs can help. Reach out today to our Business Advisory team!

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