What is a balance sheet?
A balance sheet is a financial statement that shows a company’s assets, liabilities, and shareholder equity at a specific point in time. Balance sheets serve as the basis for determining investor return rates and evaluating a company’s financial structure.
The balance sheet is a financial statement that provides a brief summary of a company’s assets, liabilities, and shareholder investment. Balance sheets can be used in conjunction with other important financial data when doing basic analysis or generating financial ratios.
How Balance Sheets Work
The balance sheet of a business provides a fast overview of its financial standing at any given time. It cannot explain the tendencies that appear over a longer period of time on its own. As a result, it is important to compare the balance sheet to those from earlier times.
Investors can assess the financial health of a firm using a variety of ratios that can be created from a balance sheet, including the debt-to-equity ratio, the acid test ratio, and many others. The income statement, statement of cash flows, and any remarks or addenda in an earnings report that might make a reference to the balance sheet all provide additional background information that is useful for assessing a company’s financial health.
A company’s assets (especially the cash account) will increase by $4,000 as a result of borrowing $4,000 from a bank over the course of five years. Its liabilities (more specifically, the long-term debt account) will increase by $4,000 as well to equalize the two sides of the equation. If the company raises $8,000 from investors, its assets and shareholder equity will both increase by $8,000. Any surplus in revenue over expenses that the company experiences will be put in the shareholder equity account. These revenues will equal out as cash, investments, inventory, or other assets on the assets side.
Because different industries use different financing strategies, it is also important to compare the balance sheets of businesses that are in the same sector.
Specific Considerations
As was already noted, a company’s balance sheet includes information about its assets, liabilities, and shareholder equity. Always check to see if the assets match the liabilities and shareholder equity. The name is a reference to the balance that the balance sheet should always have. If they don’t balance, there can be problems, such inaccurate or misplaced data, inventory or exchange rate mistakes, or incorrect calculations.
The details of a company’s finances are divided into numerous smaller accounts under each category. Even the same terminology in these accounts could have different meanings depending on the type of organization due to industry-specific variances. However, there are a few common components that investors are likely to run upon.
Shareholder Equity
Shareholder equity is the sum of money that may be linked to a company’s owners or shareholders. It is sometimes referred to as net assets since it is equal to a company’s total assets less its liabilities, or the debt it has to parties other than shareholders.
A company keeps its net profits after paying its debts and reinvesting them back into the business. The balance is distributed to the stockholders as dividends.
Treasury stock refers to shares that a company has bought back. It might be put on hold to thwart a hostile takeover or later sold to raise cash.
Under this clause, preferred stock, which certain corporations issue, will be treated differently from common stock. As with common stock, the par value of preferred stock is arbitrary and unrelated to the share’s market value. The accounts for the common stock and preferred stock are calculated by multiplying the par value of the issued shares by the quantity of shares.
Additional Paid-In Capital, also known as Capital Surplus, is the sum that shareholders have contributed above and beyond the common or preferred stock accounts, which are based on par value rather than market price. Shareholder equity and a company’s market capitalization may not necessarily correlate. Paid-in capital represents all equity acquired, regardless of price, whereas the latter is dependent on the stock’s current price.
An overview of a balance sheet’s importance
A balance sheet provides several benefits regardless of the size or industry in which a firm competes, including
Assess risk using balance sheets. This financial statement includes a corporation’s total assets and liabilities. A company will have quick access to information that will allow it to decide whether it has taken on too much debt, if its assets are sufficiently liquid, or whether it has enough cash on hand to satisfy its short-term demands.
Additionally, balance sheets can be utilized to raise capital. A balance sheet is frequently required by a lender before a business loan application is granted. When a company seeks private equity funding from investors, a balance sheet is frequently necessary. In both scenarios, the outside party looks to assess the financial health, creditworthiness, and ability of the business to repay short-term loans.
Managers can evaluate a company’s liquidity, profitability, solvency, and cadence using financial measurements (turnover). Data from the balance sheet is required for several financial ratios. When data is assessed over time or compared to similar businesses, managers can have a better understanding of how to enhance a company’s financial health.
Balance sheets can also aid in retaining talent. The majority of the time, employees want to know that their employment are secure and that their employers are doing well. Thanks to the requirement that public companies that must disclose their balance sheet, employees have the opportunity to review how much cash the company has on hand, whether the company is managing debt wisely, and whether they believe the company’s financial health is in line with what they expect from their employer.
