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The Balance Sheet

Why does it always balances and what does it tell us
MV
Written by Max Valentine
Updated 8 months ago

The Balance Sheet is one of the key financial statements used to review a company's health and efficiency. Where it differs from the other core financials statements (Income Statement and Cash flow statement) is that the Balance Sheet represents a fixed point time - think of it like a snapshot 📷 of your business.

In the Balance Sheet a value is assigned to every Asset (what the company owns) and Liability (what the company owes) of the company as at a certain date in time. It also includes the Shareholders' Equity also know as "Owners’ equity" which is the capital that investors have provided and the profits retained by the company over time, in other words, the Shareholder Value 😎.

Thus, the balance sheet provides a description of how much, and where, the company has invested (its assets)—broken down into how much of this money comes from creditors (liabilities) and how much comes from stockholders (equity). Moreover, the balance sheet gives you an idea of how efficiently your company is utilizing its assets and how well it is managing its liabilities.

As the balance sheet is a snapshot of the company to get the most use, we need to compare to the previous one to identify the movements.

Let's look at some definitions ☝

Assets

This is something that is owned by the business. Asset values are generally listed as book value, in other words, today's value of the asset. This means that the Asset has an assumed lifetime and depreciated over the course of the running the business.

The balance sheet begins by listing the assets that are most easily converted to cash: cash on hand, receivables, and inventory. These are called current assets.

Next, the balance sheet tallies other assets that have value but are tougher to convert to cash—for example, buildings and equipment. These are called fixed or long-term assets.

Since most long-term assets, except land, depreciate over time, the company must also include accumulated depreciation in this part of the calculation. Gross property, plant, and equipment minus accumulated depreciation equals the current book value of property, plant, and equipment.

Liabilities

This is something that is owed by the business. The balance sheet distinguishes between short-term liabilities, also known as current liabilities, and long-term liabilities. Short-term liabilities typically have to be paid in a year or less; they include short-term notes, salaries, income taxes, and accounts payable.

Owners’ equity comprises retained earnings (net profits that accumulate in a company after any dividends are paid) and contributed capital (capital received in exchange for stock).

The Balance Sheet should always balance ⚖ - in other words:

Assets = the Liabilities + Shareholder Equity

If a company has £5 million in assets and £2 million in liabilities, it would have owners’ equity of £3 million.

Assets = the Liabilities + Shareholder Equity

£3m = £2m + £1m

Why? Because a business needs to show what is owns - Its Assets - and where the funds were to purchase these Assets at a point in time. When creating a forecast this is a key check, as if your Balance Sheet doesn't balance there is an error somewhere.

What can we derive from the Balance Sheet:

Efficiency

The balance sheet tells you how efficiently the company is utilising its assets and how well it is managing its liabilities in pursuit of profits.

Size of the company - the value of the assets held is a quick way to value a business

Financial strength - the value and liquidity of assets versus the liabilities show how financially strong a business is and how long a business could survive bad market conditions

Shareholder Value

Shareholders' equity represents the net worth of a company, which is the amount that would be returned to shareholders if a company's total asset base was liquidated and all outstanding debts repaid. If Shareholders' equity is positive then the company has sufficient Assets to cover the Liabilities, if negative then the company is "underwater"

Working capital

Subtracting current liabilities from current assets gives you the company’s working capital. Working capital gives you an idea of how much money the company has tied up in operating activities. Just how much is adequate for the company depends on the industry and the company’s plans.

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