Basics of Balance Sheet

Accounting 101: Understanding the Basics of Balance Sheet

The official statement that defines an organization's financial position is called a balance sheet. It reveals the assets, liabilities, and the difference that in turn determines the owner's or an organization's net worth or equity.
BusinessZeal Staff
Last Updated: Jun 3, 2018
The balance sheet is a sum total of a company's income and expenses. In theory, the difference between the two determines whether or not the company is in profit or loss. The underlying principle is very simple. If the assets are more than the liabilities, the company is in a profitable position, but if the opposite is reflected, then there is a loss that has to be addressed and dealt with.

What is its Importance?

The balance sheet is an income-expenditure statement. It works like a statement for cash flow that, in time, becomes the cornerstone of the company's financial management strategies. The importance of this document affects investments made by shareholders of a company. It is structured and designed to be simple, enlisting assets on one half of the page and liabilities on the other. All the entries are linear and date-wise, which makes it easy to analyze and read.

It enables all those who are influenced by the entries to understand the company's position at any one given point in time. The entries are based on the simple equation: assets = liabilities + equity of the shareholders. This formula makes it easier for finance analysts to understand a company's position in the fiscal market.

Understanding it

The assets enlisted on the balance sheet are balanced by the financial obligations of the company, the equity investments, and retained earnings. Assets refer to the resources used by the management to operate business or transact. On the other hand, liabilities and equity function as sources that support the assets at hand. It enables the shareholders to know the value of their equity. The shareholder's equity is the amount of money, that the person or entity has initially invested into the company and the earnings thereof. The shareholder's equity works like additional resource to fund business debt.

It is an edited document that reveals the company's financial position at any single point in time. It lists both, the current and non-current assets. Current assets have a limited lifespan of maximum one year and can be converted very easily into cash. While the non-current assets cannot be converted into cash easily, and they generally have a life-span of over a year. Current assets are cash, accounts receivable and the company's inventory. Non-current ones comprise machinery, buildings, land, patents, and copyright.

Asset depreciation is calculated and then deducted from the entries. The difference represents the economic cost of the asset and this value enables an investor to calculate his or her profitability in the investment. The liabilities listed herein are the financial obligations of the company. They too are either current or long-term in nature. The company's short and long-term borrowings and accounts payables greatly affect the investor's interest in a company, and its ability to handle business competition. The shareholders' equity that is displayed on this document represents the initial amount of money invested into the business. The earnings from the investment thus earned are transferred at the end of the fiscal year, if the company decides to reinvest the net earnings. The equity discloses the company's total net worth.

How to Read it?

It is typically divided into two sides. While the assets are reflected on the left of the page, the liabilities are displayed on the right side column, along with the shareholders' equity. The entries are made date-wise and with brief details. In the asset side of the document, the accounts are classified from the most to the least liquid, and on the liabilities side, they are organized from short to long-term obligations. It is organized to enable the finance analyst to check for business growth strategies and achieve the 'balance' by calculating the value of the assets and the combined value of the liabilities and equity.

Analysis of the Balance Sheet Ratios

Once you understand the basics of the entries involved in it, it is not at all difficult to analyze the information contained within. The financial ratio analysis involves the use of certain formulas to understand the company's operations. The resultant calculation gives the analyst and subsequently the investor, a better idea of the company's financial position in the market and its efficiency. The financial strength ratio provides information to the investor on whether or not the company can meet its obligations while heading towards a worst-case scenario, like business bankruptcy. It also indicates whether the company's obligations to the fiscal market can be leveraged. This in turn, shows the investors the financial stability of the organization. Activity ratios enable the analyst and investor to gauge the versatility of the operating cycle, which include receivables and payables.

The balance sheet is an important financial tool for investors. Its purpose is to give investors an idea about the company's financial planning and current position. It is supposed to be made available at the fiscal year ending for detailed analysis and reinvestment.