What is the Balance Sheet?
A balance sheet (BS), also known as the Statement of Financial Position, is one of the three key financial statements that are used to present accounting information and outline the financial position of a company at a particular point in time. Financial position refers to the company's financial resources and obligations at a particular point in time. The main information presented in a balance sheet is the assets, liabilities, and shareholder's equity of the company. The BS is always a snapshot of one point in time, portraying the resources (assets) of a company, as well as how they were financed (liability and shareholder's equity).
The BS is split into three sections:
- Assets - what the company owns or is owed
- Liabilities - what the company owes
- Shareholder's Equity - What the shareholders own
One of the most fundamental rules of accounting and finance, and a key assumption that informs the preparation of all Statements of financial position, is the accounting equation, which states that the BS must always balance (hence the name). Assets will always be equal to Liabilities + Shareholders' Equity. It is often possible to get a basic understanding of how a company is funded just by looking at the BS.
For example, if Long Term Debt and Property, Plant and Equipment (PP&E) are both rising every year, it is reasonable to assume that the company is borrowing long-term money in order to finance long term investments in PP&E. Similarly, if the short term debt is fluctuating along with inventory then it is probable that the company is borrowing to pay suppliers (which it would do if the borrowing rate was very low and it could earn more by investing its cash and if the company received payment for products before it had to pay back the loans).
The video below briefly explains the accounting equation and how it works.
In order to understand more about each element of the Statement of financial position, let us dive deeper to understand what the assets, liabilities, and shareholders' equity of a company are.
What are Assets?
An asset is a resource owned by a company that has monetary value, can provide future economic benefit, and can be sold for cash. In the Statement of financial position, assets are broken up into two components
- Current Assets
- Non-Current Assets
Current Assets are assets that are very liquid and can be easily turned into cash. They are the assets of a company that can be or are expected to be, sold within 12 months of business operations. Current assets are generally first in the BS, representing the most liquid assets the company owns. The current assets that may be listed in a Statement of financial position are
- cash and cash equivalents (the most liquid asset)
- accounts receivables
- short-term marketable securities
These are the revenue-generating assets of a company.
Non-current assets are the assets that are harder to turn into cash. We call these assets illiquid, meaning they can't be or are not expected to be sold within the next 12 months, and generally take longer than a year to turn into cash. On the BS, these can be grouped into fixed assets, which are the tangible assets that contribute to revenue generation but are not consumed when generating revenue. Fixed assets, such as property, plant, and equipment (PP&E), usually require a significant cash outlay, and the company expects to use them for more than one accounting period. Other non-current assets include intangible assets, such as goodwill and intellectual property, which also contribute to the company's generation of revenue. Other non-current assets may include long-term marketable securities
In the Statement of financial position, the asset section will start off with listing individual current assets, along with the total current assets value, and then follow with listing each individual non-current assets, along with the total non-current assets value. The asset section of the Statement of financial position ends by combining current and noncurrent assets in a single line, listing the total assets of the company.
After the asset section of the BS, comes the liabilities section.
What are liabilities?
A liability is defined as the financial obligation of a company to outside parties. This could also arise if a company has already received payment for a product or service that hasn't been delivered yet, also known as unearned revenue (or deferred revenue), or it might be interest payments on outstanding debt.
Liabilities are also grouped in two categories:
Current liabilities are the payments that the company must make within a year. They may include items such as
- any accounts payable (e.g. interest, rent, wages, tax, etc)
- unearned revenue
- accrued expenses
- short-term debt
These are the liabilities that often finance current assets, such as inventory. These are generally listed at the start of the 'liabilities' section, with non-current liabilities following right after.
Non-current liabilities are the payments a company is obliged to make, but which extend longer than a year, and are usually used for financing capital expenditure (CapEx). A company's non-current liabilities are involved in various ratios which calculate the financial leverage of the firm, so the more non-current liabilities a company takes on, in relation to its assets, the more levered, or geared, the firm becomes, and the riskier the company will be. Non-current liabilities that are listed on a Statement of financial position may include
What is Shareholder's Equity?
Shareholder's equity commonly referred to as stockholder's equity is the amount of equity the owners of a company are entitled to after all liabilities have been paid. In terms of the accounting equation, shareholder's equity is simply what is left of the assets, after subtracting liabilities, that the owners, or shareholders, of a company, have a claim on.
Examples of items that may be included in this section are
What is important about shareholder's equity is dividends. Dividends are how companies distribute their earnings to shareholders, opting to use the free cash flow (FCF) available to pay dividends to shareholders. Although dividends are not explicitly listed in shareholder's equity, when a company does decide to make dividend payments, it impacts shareholder's equity, reducing the total amount. This is because making dividend payments reduces the value of retained earnings, as the formula for calculating retained earnings is
By increasing dividend payout, retained earnings decrease. It is important to make the distinction that dividend payments are not an expense, and so do not affect the profits of the business. They are simply a redistribution of the profits that are reported, hence why we subtract them when calculating retained profits.
Analyzing the balance sheet
The BS is an extremely important financial statement for investors, as well as company executives, to understand the financial position of a company at a certain point in time. The items in a BS, alongside the other financial statements, the income statement, and the cash flow statement, are analyzed to determine certain ratios, such as the company's return on equity (ROE), or its quick ratio.
Analysis of the Statement of financial position, combined with the other financial statements, are performed to evaluate a company across four broad categories, which are:
A few ratios to determine the profitability of a company are:
Some efficiency ratios commonly used by analysts are:
- Asset Turnover
- Inventory Turnover (or Days Inventory Outstanding)
- Accounts Receivable Turnover (or Days Sales Outstanding)
- Accounts Payable Turnover (or Days Payable Outstanding)
A few liquidity ratios utilized to determine the liquidity of the company are:
- Current ratio
- Quick ratio
Finally, the ratios that determine, or suggest, the solvency of a company include:
It is important that financial analysts utilize the Statement of financial position of a company, as well as the other two financial statements, to derive information about the financial health and performance of a business at, and over, a given period of time.
An important system used in ratio analysis is known as the DuPont System of Ratio Analysis.
What is the DuPont System?
The DuPont System of Ratio Analysis is a framework used for analyzing the fundamental performance of a company's return on equity. It essentially analyzes the different drivers of ROE, focusing on the key metrics of financial performance to identify strengths and weaknesses.
The DuPont Ratio identifies the following link between key ratios:
And the formula for ROE is
The DuPont ratio can further decompose the formula into
These are the three major financial metrics that drive ROE, and allow investors to understand what financial activities are contributing the most to changes in ROE. Although a rising ROE may seem like it is positive, if it is increased, not by adding more value but taking on more leverage, which in turn, increases the ROE, it is seen as a negative indicator.
When ROE is driven by operating efficiency (increasing profit margin) and asset use efficiency (increasing total asset turnover), it is considered as a positive, in contrast to ROE being driven by financial leverage.
Limitations of the Balance Sheet
The information included in a BS has many limitations, which may hinder an investor's ability to analyze the financial position of a company at a certain point in time.
One major limitation of the BS is that it records the value of assets at a historical value (also known as book value). This suggests that it does not show the true value of assets and is inaccurate, as the book value of assets may not reflect the actual market value of the asset.
Another limitation that decreases the accuracy of the BS is that the figures may be easily manipulated. Because it is essentially a snapshot of the financial position of a company at a particular point in time, management is able to manipulate the figures on the BS, such as by repaying debt on the final possible day to be included in the BS. The figures are practically as trustworthy as the management, who can intentionally make the financial statements misleading.
Finally, another limitation of the BS is the need to make comparisons. Analyzing a company's BS in isolation does not provide any useful information unless it is being compared to competitors in the same industry, as well as being compared to the previous year's performance. Furthermore, general market conditions must be accounted for, as they may have an impact on a company's Statement of financial position (take a look at the covid pandemic for example, due to which so many companies have had to take on increasing liabilities just to stay afloat).
Creating the Statement of financial position
The creation of a BS, for public companies, is completed through a three-step process and must be prepared in accordance with the Generally Accepted Accounting Principles (GAAP).
The three-step process of creating the balance sheet, or any of the financial statements, includes
- Preparation of the Statement of financial position, carried out by management
- Approval of the Statement of financial position, carried out by the board of directors
- Assurance of the Statement of financial position, carried out by external auditors
Management's role in ensuring financial reporting quality is having the responsibility of
- Preparing the Statement of financial position
- Making subjective judgments about the measurements of assets and liabilities
- Deciding what is recognized on the BS
The Board of Director's role in ensuring financial reporting quality is having the responsibilities of
- Approving the financial statements by 'signing it off'
- Being legally liable for the financial statements
The role of external auditors in ensuring financial reporting quality is providing an objective examination and evaluation of the BS, as well as other financial statements, ensuring it is a fair and accurate representation of the transactions the company claims to represent.
Public companies usually use one of the big four accounting firms, which are KPMG, Ernst & Young (EY), Deloitte, and PwC, to audit their financial statements, where they are required to provide an independent, unbiased, and professional opinion on whether the financial statements
- Provide a true and fair view of the company
- Complies with GAAP, as well as other reporting mandatory requirements
In very rare instances, external auditors may collude with management, issuing an auditor's opinion on a company that is false and not objective, not complying with the regulations of the Securities and Exchange Commission (SEC).