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A balance sheet, also known as a "statement of financial position", reveals a
company's assets, liabilities and owners' equity (net worth). The balance
sheet, together with the income statement and cash flow statement, make up the
cornerstone of any company's financial statements. If you are a shareholder of
a company, it is important that you understand how the balance sheet is
structured, how to analyze it and how to read it. (To learn more, check out An
Introduction To The Balance Sheet from Investopedia Video.)
Tutorial: An Introduction To Fundamental Analysis
How the Balance Sheet Works
The balance sheet is divided into two parts that, based on the following
equation, must equal each other, or balance each other out. The main formula
behind balance sheets is:
Assets = Liabilities + Shareholders' Equity
This means that assets, or the means used to operate the company, are balanced
by a company's financial obligations along with the equity investment brought
into the company and its retained earnings.
Assets are what a company uses to operate its business, while its liabilities
and equity are two sources that support these assets. Owners' equity, referred
to as shareholders' equity in a publicly traded company, is the amount of money
initially invested into the company plus any retained earnings, and it
represents a source of funding for the business.
It is important to note that a balance sheet is a snapshot of the company s
financial position at a single point in time.
Know the Types of Assets
Current Assets
Current assets have a life span of one year or less, meaning they can be
converted easily into cash. Such assets classes include cash and cash
equivalents, accounts receivable and inventory. Cash, the most fundamental of
current assets, also includes non-restricted bank accounts and checks. Cash
equivalents are very safe assets that can be readily converted into cash; U.S.
Treasuries are one such example. Accounts receivables consist of the short-term
obligations owed to the company by its clients. Companies often sell products
or services to customers on credit; these obligations are held in the current
assets account until they are paid off by the clients. Lastly, inventory
represents the raw materials, work-in-progress goods and the company s finished
goods. Depending on the company, the exact makeup of the inventory account will
differ. For example, a manufacturing firm will carry a large amount of raw
materials, while a retail firm caries none. The makeup of a retailer's
inventory typically consists of goods purchased from manufacturers and
wholesalers.
Non-Current Assets
Non-current assets are assets that are not turned into cash easily, are
expected to be turned into cash within a year and/or have a life-span of more
than a year. They can refer to tangible assets such as machinery, computers,
buildings and land. Non-current assets also can be intangible assets, such as
goodwill, patents or copyright. While these assets are not physical in nature,
they are often the resources that can make or break a company - the value of a
brand name, for instance, should not be underestimated.
Depreciation is calculated and deducted from most of these assets, which
represents the economic cost of the asset over its useful life.
Learn the Different Liabilities
On the other side of the balance sheet are the liabilities. These are the
financial obligations a company owes to outside parties. Like assets, they can
be both current and long-term. Long-term liabilities are debts and other
non-debt financial obligations, which are due after a period of at least one
year from the date of the balance sheet. Current liabilities are the company s
liabilities which will come due, or must be paid, within one year. This is
includes both shorter term borrowings, such as accounts payables, along with
the current portion of longer term borrowing, such as the latest interest
payment on a 10-year loan.
Shareholders' Equity
Shareholders' equity is the initial amount of money invested into a business.
If, at the end of the fiscal year, a company decides to reinvest its net
earnings into the company (after taxes), these retained earnings will be
transferred from the income statement onto the balance sheet into the
shareholder s equity account. This account represents a company's total net
worth. In order for the balance sheet to balance, total assets on one side have
to equal total liabilities plus shareholders' equity on the other.
Read the Balance Sheet
Below is an example of a balance sheet:
Source: http://www.edgar-online.com
As you can see from the balance sheet above, it is broken into two sides.
Assets are on the left side and the right side contains the company s
liabilities and shareholders equity. It is also clear that this balance sheet
is in balance where the value of the assets equals the combined value of the
liabilities and shareholders equity.
Another interesting aspect of the balance sheet is how it is organized. The
assets and liabilities sections of the balance sheet are organized by how
current the account is. So for the asset side, the accounts are classified
typically from most liquid to least liquid. For the liabilities side, the
accounts are organized from short to long-term borrowings and other
obligations.
Analyze the Balance Sheet With Ratios
With a greater understanding of the balance sheet and how it is constructed, we
can look now at some techniques used to analyze the information contained
within the balance sheet. The main way this is done is through financial ratio
analysis.
Financial ratio analysis uses formulas to gain insight into the company and its
operations. For the balance sheet, using financial ratios (like the
debt-to-equity ratio) can show you a better idea of the company s financial
condition along with its operational efficiency. It is important to note that
some ratios will need information from more than one financial statement, such
as from the balance sheet and the income statement.
The main types of ratios that use information from the balance sheet are
financial strength ratios and activity ratios. Financial strength ratios, such
as the working capital and debt-to-equity ratios, provide information on how
well the company can meet its obligations and how they are leveraged. This can
give investors an idea of how financially stable the company is and how the
company finances itself. Activity ratios focus mainly on current accounts to
show how well the company manages its operating cycle (which include
receivables, inventory and payables). These ratios can provide insight into the
company's operational efficiency.
There are a wide range of individual financial ratios that investors use to
learn more about a company. (To learn more about ratios and how to use them,
see our Ratio Tutorial.)
Conclusion
The balance sheet, along with the income and cash flow statements, is an
important tool for investors to gain insight into a company and its operations.
The balance sheet is a snapshot at a single point in time of the company s
accounts - covering its assets, liabilities and shareholders equity. The
purpose of the balance sheet is to give users an idea of the company s
financial position along with displaying what the company owns and owes. It is
important that all investors know how to use, analyze and read this document.
(To learn more about reading financial statements, see What You Need To Know
About Financial Statements, What Is A Cash Flow Statement? and Understanding
The Income Statement.)
by Investopedia Staff
Investopedia.com believes that individuals can excel at managing their
financial affairs. As such, we strive to provide free educational content and
tools to empower individual investors, including thousands of original and
objective articles and tutorials on a wide variety of financial topics.