Balance sheet definition
A balance sheet summarizes a company's assets, liabilities and shareholders’ equity at a specific point in time. It is one of the fundamental documents that make up a company’s financial statements.
Your balance sheet gives you a summary of your company’s financial position at a point in time and provides a clear picture of what you own and what you owe. A continuous series of balance sheets allows you to track your company’s liquidity over time.
Banks and investors will also look at the balance sheet to better understand the financial health of your company before investing in it or lending you money.
“The balance sheet not only provides you with a snapshot of what the company is like at that moment, but it’s an important document used by lenders to assess a loan request,” says Fanny Cao, Senior Advisor, Product Development at BDC.
Cao says a balance sheet allows you to see how the company is performing financially and if it has sufficient funds to invest in its operations. “It classifies your assets and liabilities by short- and long-term. You see the obligations that you have to meet within the next year.”
The 5 main parts of a balance sheet
2. Fixed assets
Property or equipment the company owns and uses in its operations to generate income. Fixed assets are purchased for long-term use (longer than one year). Their value decreases over time because of wear and tear. This change is recorded as depreciation on the income statement.
Debts and other obligations to creditors that will be due within the next 12 months. Examples of current liabilities include accounts payable, credit card bills, sales taxes collected, payroll liabilities and loan payments.
Debts and other obligations to creditors that will not be due in the next 12 months. Examples of long-term liabilities include term loans and mortgages.
What are the uses of a balance sheet?
A balance sheet is used to measure some of the company’s key ratios, including the debt-to-equity ratio, the debt-to-asset ratio and the current ratio at set periods, such as in yearly, quarterly or monthly reports. Other ratios will calculate information from the income statement and the statement of cash flows that refer back to the balance sheet.
“It offers a way to see how efficient and how liquid the company is,” says Cao. “As a lender, we use your balance sheet to see how comfortable we would be in lending money to your company.”
The balance sheet also reveals the book value of a company’s assets, liabilities and shareholders’ equity.
Cao says a balance sheet’s figures will lay out both the short- and long-term assets and liabilities. “You want to make sure that current assets are higher than current liabilities. It
will help you to know that if you have to pay down all your current liabilities tomorrow, you would have enough cash available from your current assets.”
How to read a balance sheet
When looking at your balance sheet, your total assets should always equal your total liabilities plus shareholder’s equity.
This simple formula tells you that everything a company owns was either paid by borrowing money (liabilities) or by taking it from investors, either through paid-in capital, or by reinvesting its profits through retained earnings.
The balance sheet is also deeply connected to the other financial statements and can’t really be analyzed independent of the other statements.
Let’s say you decide to buy a truck. That truck will show up as an asset on the top of your balance sheet, while the loan you took out to purchase the truck will be shown as a liability at the bottom.
At the end of the financial year, your accountant will record in the income statement a depreciation expense that represents the reduction in the value of the truck resulting from wear and tear. (Depreciation is calculated based on the useful life of the asset.)
The cash flow statement takes your net income and adds back the depreciation because it is not a cash expense. These changes in turn affect the ending cash balance, which will be shown on the balance sheet. The truck will be shown on the balance at a reduced value because of depreciation.
The notes to the financial statements explain any assumptions made during the preparation of the balance sheet. Accountants will indicate if the statement has been prepared according to the International Financial Reporting Standards.
Example of a balance sheet
In the balance sheet below, you can see that assets are at the top of the balance sheet and are divided into current and fixed assets (also called long-term or capital assets). Both types of assets are listed in descending order starting with those that can most easily be converted into cash.
That same logic applies to the liabilities and shareholders’ equity sections, where the most liquid elements appear first. Showing two years on a balance sheet allows you to track changes from one reporting period to the next.
What is a balance sheet also known as?
A balance sheet can also be referred to as a statement of financial position or a statement of financial condition.
Free balance sheet template for entrepreneurs
You can download our free, fillable template balance sheet if you need to manually create one. However, note that we generally advise clients to generate their financial statement through an accounting software or with the help of their accountant.
How does a banker look at a balance sheet?
When a banker analyzes your company’s balance sheet, he or she calculates specific ratios to determine whether your business will be able to repay the loan.
One of the ratios they will calculate is the current ratio (also called the working capital ratio), which measures your company’s ability to pay its current liabilities with its current assets. Investors will also calculate this ratio before investing in your business.
The current ratio is calculated as follows:
Current ratio = current assets ÷ current liabilities
Let’s calculate the current ratio for ABC Co. using the balance sheet example above. It shows that the company’s current assets in Year 1 totaled $120,000, while its current liabilities totaled $70,000. This makes for a current ratio of 1.71, meaning that the company has $1.71 available to pay every dollar of debt.
As a general rule, higher current ratios indicate a lower risk that the business will run out of cash. If your current ratio is well above 1, your company is more likely to meet its financial obligations. If your current ratio falls close to 1, paying all your bills on time will become more difficult.
Another ratio bankers and investors use to evaluate your company’s finances is the debt-to-equity ratio. It compares the percentage of financing that comes from creditors and investors to the amount of equity held by shareholders.
The debt-to-equity ratio is calculated as follows:
Debt-to-equity ratio = debt ÷ equity
Let’s calculate the debt-to-equity ratio using ABC Co.’s balance sheet shown above. It shows that the company carried $130,000 in long-term debt and $3,750 in short-term debt in Year 1, while investors held $100,000 of equity in the business. This makes for a debt-to-equity ratio of 1.34.
Many companies have a ratio that is considerably higher than 1, meaning they have more debt than equity. Generally speaking, capital-intensive industries have a higher debt-to-equity ratio. An example of this would be a trucking company.
Balance sheet vs. income statement
The balance sheet shows a company’s total assets and liabilities at a specific point in time. The income statement shows a company’s revenues, expenses and profitability over a specific period, usually a month, a quarter or a year.
Does the balance sheet show net income?
A balance sheet does not show net income directly. However, net income is used to calculate retained earnings, which are the amount of profit a company has left over after paying all costs, taxes and dividends.
Do accounts receivable go on a balance sheet?
Yes, accounts receivable are typically included on a company’s balance sheet as a current asset.
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