Regularly analyzing the financial position of a business is vital to keep an organization on track. And the balance sheet is one of the most important financial statements for analysis, because it provides a snapshot of your company’s net worth for a specific time.
What is a balance sheet?
A balance sheet is an accounting report that provides a summary of a company’s financial health for a specified period. Also known as a statement of financial position, the summary reports the company’s assets, liabilities, and equity in one page.
Knowing how to produce a balance sheet is essential. Business owners review it to track company earnings and spending. Lenders and creditors consider balance sheet data when making decisions on whether a company qualifies for bank loans or a corporate credit card. Potential investors analyze a company’s performance by examining what a business owns versus what it owes. These scenarios are three of the most typical, but there are many other uses for a balance sheet.
How to make a balance sheet.
The balance sheet includes three components: assets, liabilities, and equity. It's divided into two sides — assets are on the left side, and total liabilities and equity are on the right side. As the name implies, the balance sheet should always balance. The assets on the left will equal the liabilities and equity on the right.
A balance sheet reflects the number of assets and liabilities at the final moment of the report or accounting period. Most balance sheet reports are generated for 12 months, although you can set any length of time. The final numbers reflect the condition of the company on the last day of the report.
When creating a balance sheet, the items should be listed in order by liquidity, starting with the most liquid assets, such as cash and inventory on top. Harder to liquidate items go towards the bottom of the list.
Balance sheet equation.
The balance sheet should conclude with two columns with corresponding figures at the bottom.
The basic accounting equation is:
Assets = Liabilities + Equity
The assets on the left will equal the liabilities and equity on the right. When reviewing a balance sheet, the two columns will reflect the balance sheet equation with line-item accounts showing how the two sides add up.
The three aspects of a balance sheet in detail.
The three items needed for the balance sheet equation are the assets, liabilities, and equity. Here’s a closer look at how to make a balance sheet using the three parts.
Assets.
Assets include everything a business owns that can be quantified in dollars. Report assets as a debit except accumulated depreciation accounts that have credit balances. Examples of assets on a company's statement of financial position include:
- Cash
- Inventory
- Supplies
- Accounts receivable
- Prepaid expenses
- Equipment, vehicles, and machinery
- Furniture and fixtures
- Land, buildings, and properties
- Improvements
The last four assets are known as fixed or long-term assets. They are expected to last longer than a year and can depreciate over time.
Depending on the complexity of your business, you may need classified balance sheets. In the case of a detailed balance sheet, accounts are grouped and presented by categories. The most common asset classifications, arranged by order of liquidity, are:
- Current assets
- Investments
- Property, plant, and equipment
- Intangible assets
- Other assets
Liabilities.
Liabilities are a company’s obligations — the amounts owed to creditors. Total liabilities are usually reported as credit balances. Along with owner’s or shareholders’ equity, they’re located on the right-hand side of the balance sheet to display a claim against a business’s assets.
For example, a business balance sheet reports $250,000 in assets, $150,000 in liabilities, and $100,000 in owner’s equity. The creditors have a claim of $150,000 against the company’s $250,000 in assets. Once the debts are paid off, the owner can claim their equity of $100,000.
Typical liability accounts listed on a firm’s balance sheet include:
- Accounts payable
- Salaries and wages payable
- Interest payable
- Income taxes payable
- Customer deposits
When creating a classified balance sheet, liability accounts are organized as short-term or long-term debt (in order of appearance):
- Current liabilities
- Long-term liabilities
Long-term liabilities include capital leases, deferred compensation, and bank loans with a term of more than one year.
Owner’s or stockholders’ equity.
Equity is equal to assets minus liabilities and is the amount of owner capital invested in the firm. It’s also referred to as a company’s book value. Owner's equity relates to businesses that are sole proprietorships, and stockholders' equity refers to corporations. As with liabilities, owner’s and stockholders' equity accounts are reported as credits.
An example of how an owner's equity account will display equity is a single line showing the sole proprietor’s name: Mark Johnson, Capital. A stockholder equity section features more accounts than an owner’s equity section of the balance sheet. Three typical stockholder equity accounts are:
- Preferred stock
- Common stock
- Retained earnings
Sample balance sheet.
Review the above balance sheet example from Apple, Inc., to understand how to read a balance sheet. Regardless of the company’s size, a balance sheet should be clear and straightforward. Both columns list their line items with a total that equals the other, to balance.
Not all balance sheets use a left-right or double-entry accounting formation. When comparing other time frames, the balance sheet may be displayed as stacked sections. Nevertheless, it’s clear to see how each portion of the balance sheet equation adds up and balances.
How to read a balance sheet.
The balance sheet provides a snapshot of several important factors about a business. Reviewing the statement will provide valuable financial information on the following factors.
Liquidity.
Comparing a company’s assets to its liabilities for a certain period offers a picture of company liquidity — when the current assets are greater than current liabilities, the business has cash flow to cover its short-term financial obligations. The line items towards the top of the assets section are the most liquid, meaning those assets can be converted to cash the fastest.
Leveraging.
Comparing debt to owner or shareholders’ equity is a common way of analyzing leverage on the balance sheet. When liabilities or debt is high, a conservative investor may be alarmed. But higher liabilities do not necessarily mean the business is in trouble — the company may be strategically leveraged.
Leverage describes how much of a company's working capital comes from debt and can be a useful metric of the financial risk a company is taking. Leveraged businesses may be aggressively pursuing expansion and need to incur debt to grow.
Rate of Return.
Potential investors like to know how well a company earns returns — it helps them decide whether an investment in a company will be profitable. Calculations like Return on Invested Capital (ROIC), Return on Equity (ROE), and Return on Assets (ROA) all require the information provided on the balance sheet to find the rate of return ratios.
Dividing the net income into liabilities, plus equity, results in the Return on Invested Capital (ROIC). To find the ROE figure, divide the company’s net income into the shareholders’ equity. Dividing net income into total assets outputs the ROA number.
Efficiency.
Working with both the balance sheet and income statement can reveal how efficiently a company is using its current assets. The asset turnover ratio (ATR) is one way to gauge efficiency by dividing a company’s revenue by its fixed assets to find out how the company is converting its assets into income.
The purpose of a balance sheet.
Knowing how to create and read a company’s balance sheet is essential to understanding the state of a business. You can generate a balance sheet for any specified period — many companies will create a multi-year balance sheet that compares how a firm has progressed over its recent history.
The summarized data displayed on one single sheet can provide detailed information on the condition of the company. Creating a year-end balance sheet will keep you on top of how your company is performing and if it’s on track to meet your goals.
