The balance sheet is one of the three fundamental financial statements in bookkeeping. The purpose of this statement is to illustrate the book value of a company by listing its assets, liabilities, and equity. Companies use it to assess financial standing, guide business decisions, prove creditworthiness to lenders and investors, and attract better talent.
What is a Balance Sheet?
Double-entry bookkeeping divides value into five dedicated accounts: assets, liabilities, equity, expenses, and revenue. These accounts can be categorized into two distinct groups: permanent and temporary.
Permanent accounts include assets, liabilities, and equity. They have cumulative balances and represent the business’s ongoing progress. Meanwhile, temporary accounts, which include expenses and revenue, represent activity within a specific accounting period and reset their balances once a new period begins.
The purpose of the balance sheet is to illustrate financial standing in a given period of time by listing the value of its permanent accounts. It summarizes what a company owes and owns by enumerating assets, liabilities, and equity.
The Balance Sheet Formula
Double-entry bookkeeping is founded on the principle of debits and credits, which states that every transaction has two sides: one that places value into the business (debits) and one that returns value to a source (credits). Similarly, the balance sheet proves that all assets a business owns are paid for by outside sources, such as debtors and shareholders.
This principle can be mathematically translated into the fundamental accounting equation, which states that assets are equal to the sum of liabilities and shareholder’s equity.
Assets = Liabilities + Equity
The accounting equation is the basis of the balance sheet. If assets do not match the sum of liabilities and shareholder’s equity, you’ve miscalculated the value of your accounts.
Balance Sheet Example
Below is an example of a balance sheet reflecting the value of assets, liabilities, and shareholder’s equity over a one-year period.
Example Co. Balance Sheet | |
Assets | |
Current Assets | |
Cash | $50,000 |
Accounts Receivable | $140,000 |
Inventory | $160,000 |
Total Current Assets | $350,000 |
Fixed Assets | |
Vehicles | $200,000 |
Equipment | $185,000 |
Intangible Assets | $15,000 |
Total Fixed Assets | $400,000 |
Total Assets | |
Liabilities | $750,000 |
Current Liabilities | |
Accounts Payable | $35,000 |
Taxes Payable | $40,000 |
Term Debt | $25,000 |
Total Current Liabilities | $100,000 |
Non-Current Liabilities | |
Term Debt | $150,000 |
Total Liabilities | $250,000 |
Shareholder’s Equity | |
Owner’s Capital | $100,000 |
Common Stock | $250,000 |
Retained Earnings | $150,000 |
Total Shareholder’s Equity | $500,000 |
Total Liabilities and Shareholder’s Equity | $750,000 |
As you can see, total assets match the sum of liabilities and equity.
Main Components of a Balance Sheet
The components of the balance sheet represent the three permanent account types: assets, liabilities, and equity. Below, we define the three components and list examples of account types included in each.
Assets
Assets are resources that the company owns or controls. These include current assets, which are highly liquid and can be converted to cash within the short term, and long-term assets, which are difficult to liquidate and can support operations in the long term.
Typically, assets in the balance sheet are listed in descending order of liquidity. This structure helps elucidate the company’s financial strength and capacity to generate cash.
Below are a few common examples of short-term assets in order of liquidity.
- Cash, including cheques and non-restricted bank accounts.
- Cash equivalents include money market accounts, short-term certificates of deposit, treasury bills, short-term government bonds, and banker’s acceptance.
- Marketable securities are items that are easy to convert into cash. These include certain types of stocks, bonds, and commercial papers.
- Accounts receivable are short-term debts owed to the company by customers.
- Inventory refers to items that the business intends to sell.
- Prepaid expenses include services paid for in advance, such as rent, subscriptions, contracts, and reservations.
After short-term assets, the balance sheet lists long-term assets in order of liquidity:
- Long-term investments include any security that cannot be liquidated in a year, such as long-term CDs, mutual funds, and ETFs.
- Fixed assets are tangible, high-value resources that contribute to revenue-generating activities. Examples include property, buildings, equipment, and vehicles.
- Intangible assets are resources that lack a physical form but contribute to the company’s economic benefit. Copyrights, trademarks, licenses, and patents are common examples of intangible assets.
Liabilities
Liabilities are financial obligations owed to creditors. Like assets, they can be categorized by temporality, with current liabilities due within at most a year of reporting and long-term or non-current liabilities due at least one year after. All liabilities should be listed on the balance sheet in order of their due date.
Examples of liabilities include:
- Current liabilities include accounts payable, wages payable, dividends payable, customer prepayment obligations, unearned revenue, and current portions of long-term debt.
- Non-current liabilities include long-term debt, post-employment benefits, and deferred tax liability.
Shareholder’s Equity
Shareholder’s equity refers to value invested by owners or shareholders. It is also the amount left over after a business liquidates its assets and debt.
Common examples of equity include:
- Owner’s capital, which is the amount the owner has invested in the business
- Stocks, such as common stock, preferred stock, and treasury stock
- Retained earnings are earnings the company spends on debt or reinvestment
What is the Purpose of the Balance Sheet?
The balance sheet provides evidence of a company’s financial position. It helps creditors, investors, and even talent determine whether working with your company would provide mutual benefit.
Evaluating Financial Health
The primary purpose of the balance sheet is to prove financial standing. Companies compare balance sheets across reporting periods to evaluate progress. They also use it to guide future business decisions. For example, a company can compare assets to debt and equity to determine whether it is in a stable enough position to take on additional debt.
Securing Business Loans
Banks and other financial institutions examine each loan applicant’s financial situation to determine the risk of lending money to them. The balance sheet provides proof that you can generate enough liquid assets to pay your creditors on time.
Attracting Investors
Like creditors, investors want proof that they’ll get a return on their investment if they provide funding for your business. The balance sheet shows the value of your assets, liabilities, and equity to prove your income generation capacity and sustainability.
Luring and Retaining Talent
The best applicants in the job market prefer stable businesses. Balance sheets assure applicants that your company can run itself effectively enough to pay compensation and sustainably enough to create long-term partnerships with its contractors and employees.
How to Prepare a Balance Sheet
Today’s businesses typically prepare balance sheets using accounting software, which use your digital journal entries to generate financial statements automatically. However, knowing how to execute the process manually can help you better ensure accuracy.
1. Select a Reporting Date
Your balance sheet reports your financial standing at a given point in time. Preparing your balance sheet starts with identifying the point in time you aim to highlight. Reporting dates typically fall at the end of a given accounting period.
Because balance sheets highlight data from a specific point in time, regular reporting is necessary. Consistently reporting financial statements allows you to compare accounting periods and gauge the effects of business decisions, seasonal changes, and other external factors.
Companies typically prepare balance sheets every quarter. However, if your business is undergoing rapid growth or change, you can better account for its changes with monthly balance sheets.
2. Gather Relevant Documents
Gather all relevant financial documents from your selected reporting period. These include:
- General Ledger: This provides an easy reference for all account values.
- Bookkeeping Journals: General journal entries and other bookkeeping journals can provide additional information about the transactions posted in the general ledger. This helps you spot errors before they carry over to reports.
- Invoices and Receipts: These documents prove that transactions occurred, helping you identify missing entries, correct erroneous entries, and ensure accuracy.
- Trial Balance: A trial balance is an optional tool that lists the balances of all accounts to ensure that debits and credits are balanced.
- Income Statement: You need your income statement to calculate retained earnings, which appears in the shareholder’s equity section.
3. Calculate Assets
Once you have all your reference documents, list all assets in order of liquidity, beginning with cash. Typically, companies will create separate subsections for current and non-current assets.
Finally, add up the totals of all asset accounts. We’ll use the example above to illustrate what your document might look like:
Assets | |
Current Assets | |
Cash | $50,000 |
Accounts Receivable | $140,000 |
Inventory | $160,000 |
Total Current Assets | $350,000 |
Fixed Assets | |
Vehicles | $200,000 |
Equipment | $185,000 |
Intangible Assets | $15,000 |
Total Fixed Assets | $400,000 |
Total Assets | $750,000 |
4. Calculate Liabilities
In the balance sheet, the liability section follows the asset section. It lists all liability accounts according to due dates. Similar to assets, the liability section is often divided into subsections for current and non-current liabilities.
Once all accounts have been listed, calculate total liabilities.
Liabilities | |
Current Liabilities | |
Accounts Payable | $35,000 |
Taxes Payable | $40,000 |
Term Debt | $25,000 |
Total Current Liabilities | $100,000 |
Non-Current Liabilities | |
Term Debt | $150,000 |
Total Liabilities | $250,000 |
5. Calculate Shareholder’s Equity
Shareholder’s equity is the last section on the balance sheet. Simply list all shareholder’s equity accounts, beginning with owner’s capital, then private stock, then public stock, and then retained earnings. Once all accounts are listed, get the total.
Shareholder’s Equity | |
Owner’s Capital | $100,000 |
Common Stock | $250,000 |
Retained Earnings | $150,000 |
Total Shareholder’s Equity | $500,000 |
6. Validate Balance Through the Accounting Equation
The accounting equation states that assets are equal to the sum of liabilities and shareholder’s equity. Add total liabilities to total shareholder’s equity, and then write the sum under the shareholder’s equity section.
If the totals of all three sections are true to the accounting equation, then you’ve reported your balance sheet correctly. However, if the totals do not match, you need to go back and identify your error.
In the example above, assets amounted to $750,000, liabilities $250,000, and shareholder’s equity $500,000. $250,000 + $500,000 = $750,000, which means the balance sheet was recorded accurately.
How to Evaluate a Balance Sheet
The primary purpose of the balance sheet is to illustrate the company’s financial standing. The information provided in the balance sheet helps companies access multiple financial performance indicators. Below are a few of the most critical indicators to consider when evaluating balance sheets.
Performance Indicator | Formula |
Working Capital | Current Assets – Current Liabilities |
Current Ratio | Current Assets / Current Liabilities |
Quick Ratio | (Current Assets – Inventory) / Current Liabilities |
Debt-to-Asset Ratio | Total Liabilities / Total Assets |
Debt-to-Equity Ratio | Total Liabilities / Total Equity |
Return on Assets | Net Income / Total Assets |
Working Capital
This metric shows how much money is available to buy inventory and pay loan interest. It is the result of subtracting current liabilities from current assets.
Low working capital indicates that the business struggles to pay for operating expenses and debt. Meanwhile, high working capital might imply that not enough surplus funds are being reinvested in the business.
Current Ratio
The current ratio contrasts the amount of current assets to current liabilities. It shows how easily a business can cover short-term financial obligations given its short-term assets.
Companies should strive for a ratio of 1.5 to 2. Balanced ratios imply that the company can cover short-term obligations and still take on additional debt. Ratios lower than one imply that the company is too heavily reliant on debt and will struggle to take additional liabilities.
Quick Ratio
The quick ratio formula is a modified version of the current ratio formula that removes the impact of inventory. It measures a company’s capacity to cover short-term liabilities without liquidating inventory or taking on additional debt.
Because it removes inventory, the quick ratio offers a more conservative metric of a business’s ability to cover short-term financial obligations. It assumes that inventory will be difficult to liquidate and aims to be a more accurate measure of liquidity.
A ratio of 1 is considered a normal and balanced ratio. Ratios lower than 1 imply a lower capacity to pay short-term debt with liquid assets.
Debt-to-Asset Ratio
This ratio divides total liabilities by total assets to determine what percentage of your assets relies on debt for financing. It allows creditors to assess the level of risk involved in lending money to your business.
Higher ratios imply a high dependence on debt. Creditors will be reluctant to lend you money because your borrowing either exceeds or insufficiently supports your asset-building activities.
Debt-to-Equity Ratio
This divides total liabilities by total equity to determine which funding source the company is more dependent on. It is another indicator creditors use to evaluate the risk of lending to your business.
Debt-to-equity ratios of 1 and lower are considered healthy because they imply that operations rely more on shareholder funding than debt. Meanwhile, high ratios imply a reliance on debt for operations, which might cause creditors to consider your business high-risk.
Return on Assets
Return on assets compares net income against total assets to evaluate a company’s efficiency in using its resources to generate profit. The higher the number, the more efficient a company is.
Outsource Financial Reports to EpicBooks
The balance sheet is a useful tool for illustrating a company’s overall value. It summarizes everything your business owes and owns, helping illustrate its financial position at a given point in time. You can use the balance sheet to assess your operational effectiveness or assure investors, job applicants, and creditors that your business is worth working with.
If you want to benefit from accurate financial reporting without taking time away from core business activities, consider outsourcing your bookkeeping to EpicBooks. Our expert bookkeepers will alleviate the manual load of financial management, helping you record transactions, generate reports, and create effective finance strategies.
We help you with your statements so you can focus on success. Read the EpicBooks services page for more information.
FAQs
What is the difference between the balance sheet and the trial balance?
The trial balance is a tool that helps companies identify discrepancies in recorded debits and credits. Companies use trial balances to prevent mistakes in reporting activity in official financial statements. The balance sheet, on the other hand, reports final values for assets, liabilities, and shareholder’s equity.
What is the difference between the balance sheet and the cash flow statement?
The balance sheet summarizes the value of all assets, liabilities, and shareholder equity to provide a snapshot of the company’s financial standing within a given period. Meanwhile, the cash flow statement lists cash inflows and outflows to illustrate its capacity to generate cash. The balance sheet is better for examining a company’s overall value, while the cash flow statement is better for assessing the effectiveness of cash-generating activities.
What is the difference between the balance sheet and the income statement?
The balance sheet deals with permanent accounts: assets, liabilities, and equity. It shows a company’s book value at a given point in time. Meanwhile, the income statement deals with temporary accounts: expenses and revenue. It reflects the company’s gains and losses over a designated period. The balance sheet is better for assessing a company’s long-term progress, while the income statement is better for examining the impacts of short-term efforts.