Balance sheets adhere to the following formula:
Assets = Liabilities + Shareholders’ Equity
Balance sheets gets their name from the fact that the two sides of the equation above – assets on the one side and liabilities plus shareholders’ equity on the other – must balance out. This is intuitive: a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholders’ equity).
For example, if a company takes out a five-year, $4,000 loan from a bank, its assets – specifically the cash account – will increase by $4,000; its liabilities – specifically the long-term debt account – will also increase by $4,000, balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholders’ equity. All revenues the company generates in excess of its liabilities will go into the shareholders’ equity account, representing the net assets held by the owners. These revenues will be balanced on the assets side of balance sheets, appearing as cash, investments, inventory, or some other asset.
Assets, liabilities and shareholders’ equity are each comprised of several smaller accounts that break down the specifics of a company’s finances. These accounts vary widely by industry, and the same terms can have different implications depending on the nature of the business. Broadly, however, there are a few common components investors are likely to come across.
Within the assets segment on balance sheets, accounts are listed from top to bottom in order of their liquidity, that is, the ease with which they can be converted into cash. They are divided into current assets, those which can be converted to cash in one year or less; and non-current or long-term assets, which cannot.
Here is the general order of accounts within current assets:
- Cash and Cash Equivalents – the most liquid assets, these can include Treasury bills and short-term certificates of deposit, as well as hard currency.
Marketable Securities – equity and debt securities for which there is a liquid market.
Accounts Receivable – money which customers owe the company, perhaps including an allowance for doubtful accounts (an example of a contra account), since a certain proportion of customers can be expected not to pay.
Inventory – goods available for sale, valued at the lower of the cost or market price.
Prepaid Expenses – representing value that has already been paid for, such as insurance, advertising contracts or rent.
Long-term assets include the following:
Long-term Investments – securities that will not or cannot be liquidated in the next year.
Fixed Assets – these include land, machinery, equipment, buildings and other durable, generally capital-intensive assets.
Intangible Assets – these include non-physical, but still valuable, assets such as intellectual property and goodwill; in general, intangible assets are only listed on the balance sheet if they are acquired, rather than developed in-house; their value may therefore be wildly understated—by not including a globally recognized logo, for example—or just as wildly overstated.
Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within one year and are listed in order of their due date. Long-term liabilities are due at any point after one year.
Current liabilities accounts might include:
- Current portion of long-term debt
Rent, tax, utilities
Dividends payable and others
Long-term liabilities include:
Long-term Debt interest and principal on bonds issued.
Pension Fund Liability the money a company is required to pay into its employees’ retirement accounts.
Deferred Tax Liability taxes that have been accrued but will not be paid for another year; besides timing, this figure reconciles differences between requirements for financial reporting and the way tax is assessed, such as depreciation calculations.
Some liabilities are off balance sheets, meaning that they will not appear on balance sheets.
- Operating Leases
Shareholders’ Equity is the money attributable to a business’ owners, meaning its shareholders. It is also known as net assets, since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to non-shareholders.
Retained Earnings are the net earnings a company either reinvests in the business or uses to pay off debt; the rest is distributed to shareholders in the form of dividends.
Treasury Stock is the stock a company has either repurchased or never issued in the first place. It can be sold at a later date to raise cash or reserved to repel a hostile takeover.
Some companies issue preferred stock, which will be listed separately from common stock under shareholders’ equity. Preferred stock is assigned an arbitrary par value—as is common stock, in some cases—that has no bearing on the market value of the shares (often, par value is just $0.01). The common stock and preferred stock accounts are calculated by multiplying the par value by the number of shares issued.
Additional paid-in capital or capital surplus represents the amount shareholders have invested in excess of the common stock or preferred stock accounts, which are based on par value rather than market price. Shareholders’ equity is not directly related to a company’s market capitalization: the latter is based on the current price of a stock, while paid-in capital is the sum of the equity that has been purchased at any price.
How To Interpret a Balance Sheet
Balance sheets are a snapshot, representing the state of a company’s finances at a moment in time. By themselves, balance sheets cannot give a sense of the trends that are playing out over a longer period. For this reason, the balance sheet should be compared with those of previous periods. It should also be compared with those of other businesses in the same industry, since different industries have unique approaches to financing.
A number of ratios can be derived from the balance sheet, helping investors get a sense of how healthy a company is. These include the debt-to-equity ratio and the acid-test ratio, along with many others. The income statement and statement of cash flows also provide valuable context for assessing a company’s finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet.
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