Editor’s Note: This is the first in a series about the balance sheet. Follow the series in the related content section.
The balance sheet is an important accounting document that’s also known as the statement of financial position. It’s intended to show how much a company is worth — or its book value.
A balance sheet breaks a company’s financial position down into three parts – assets, liabilities, and owners’ equity – as of a particular date referred to as the reporting date.
The balance sheet provides an assessment of the overall health of a business, which is useful for investors and potential investors, as well as company leadership and employees.
It can be prepared on a quarterly or monthly basis, as well as annually, depending on the frequency of reporting as determined by applicable laws, audit requirements and/or company policy.
Here are the key components of a balance sheet:
Assets
An asset is anything that is owned and has an inherent, quantifiable value. If necessary, assets can be converted into cash by selling or liquidating them. Assets are usually positives (+) in a balance sheet.
Current assets include anything a company expects it will convert into cash within a year.
Non-current assets include long-term investments that aren’t expected to be converted into cash in the short term.
Liabilities
A liability is the opposite of an asset; it’s what is owed as opposed to owned. Liabilities are financial obligations that must be paid, which is why they’re usually negatives (-) in a balance sheet.
Current liabilities refer to any liability due to creditors within one year.
Non-current liabilities refer to any long-term obligations or debts that are not due in the next 12 months.
Owners’ or Shareholders’ Equity
Owners’ equity is the term for sole proprietorships and partnerships, while shareholders’ equity is used for publicly-traded companies and non-public corporations. This generally encompasses anything that belongs to a business, after all liabilities have been deducted. The residual interest in company assets after deducting total liabilities, represents the business’ net worth.
Owners’ equity is typically comprised of two key elements:
- The money that’s been contributed to the business in the form of an investment, in exchange for an ownership stake in the company – most often in the form of shares (that may or may not be publicly traded).
- Retained earnings, which are the profits that a business ‘retains’ after all expenses and dividends have been paid. They can be used to invest in things like research and development, expansion, new equipment, and marketing.
Owner’s equity accumulates over time and grows when owners increase their investment or company profits rise.
Notes
Otherwise known as explanatory notes or financial statement footnotes. These are an essential part of any financial statement and often as important as the statement itself. They might contain critical information not found on the actual balance sheet. Always read the notes.
The notes contain information on the accounting policies applied, as well as any judgments or estimates used in the preparation of the balance sheet. Notes can be in the form of text, tables, and graphs. They might explain how the company recognizes revenue or calculates write-offs. Companies include all kinds of things in the notes.
Overall, notes are mostly intended to protect the company from legal liability. How they are structured and what information is included is at the discretion of company management and their accountants.
The most important accounting equation
A balance sheet must always balance and it’s most important equation is:
ASSETS = LIABILITIES + OWNERS’ EQUITY
If the balance sheet doesn’t balance, it’s incorrect.
There can be errors due to missing figures, incorrect transactions, currency exchange issues, inaccurate inventory readings, improper equity calculations, and depreciation mistakes.
