What is a Balance Sheet?
How much does a company have in assets? How much does it owe to its suppliers, the banks, and bondholders? To determine this, we need to look at the Balance Sheet. But what is a Balance Sheet? A Balance Sheet is simply a report of the health of a business at a given point in time. It is broken into three parts: Assets — what the company owns like property, cash, inventory, etc. Liabilities — what the company owes to suppliers, banks, bondholders, etc. Shareholder's Equity — the difference between assets and liabilities. Shareholder's equity represents the net worth of the business.
An important thing to remember about a Balance Sheet — it provides a snapshot of the company's financial condition. The numbers pertain only to the specific date indicated on it. The Balance Sheet is prepared at the close of business on the last day of the Income Statement period.
Breaking it Down
The best way to explain the details of a Balance Sheet is to break it down into its components with an example. It's time to dust off our trusty Smart Widgets Inc. Balance Sheet.
ASSETS
Assets are what the company owns. Let's look at the different line items that are covered under Assets. These can be classified into three main categories — current assets, long-term operating assets, and other assets.
Current Assets: This includes cash and any asset that can easily be converted to cash within a very short period of time, typically within a year. Current assets are also called "working assets". They are converted to cash within an operating cycle ..... Cash — Buy/Manufacture products — Sell — Wait to collect receivables from sale — Receive cash. Cash and Short-Term Investments:
Actual cash that the company has and short-term investments like short-term CDs, three-month T-Bills, or other highly liquid assets. Total Receivables, Net:
Usually, when a company sells its products, it doesn't receive the payment immediately, but in about thirty days. This creates a lag in cash inflow and the amount of this lag is called "Accounts Receivable". Once we account for bad debt from defaulting customers, we get Net Receivables. Total Inventory:
In order to effectively sell its products, a company needs to maintain a stock of these products on hand. This is called inventory. An important point about inventory .... it's reported at how much it cost to build the product and not the value it would be sold for to the customer. Prepaid Expenses:
If there are any goods or services that a company has already paid for but hasn't received, it's accounted as a prepaid expense. Insurance premiums paid in advance are an example. Other Current Assets, Total:
These are any other non-cash assets that are due within a year but are not yet in possession of the company. Total Current Assets:
Sum of all the line items above gives the total current assets. This is an indication of whether a company can meet its short-term debt obligations or not. Long-term Operating Assets: These are assets used in the operations of the business and are not held for sale to customers. They fall into two categories — tangible and intangible assets. Property/Plant/Equipment, Total - Net
This includes the original cost paid for land, buildings & structures, machinery & equipment, etc. less accumulated depreciation. Every year since their purchase, these items lose value due to use. Depreciation is a charge taken to account for this. Accumulated depreciation is the sum of this charge over the useful lifespan of these assets. Goodwill, Net
When a company acquires other companies, it usually pays more than the book value of those companies. This excess is called goodwill. Why pay goodwill? The companies being acquired might have a strong brand, or a list of dedicated customers, or may own a desirable patent or secret product formulation. The price for these intangibles is accounted as goodwill. Intangibles, Net
Intangibles are assets you can't touch — patents, copyrights, trademarks, brand names, etc. Long-Term Investments
This represents the companies investments in stocks, bonds, real estate, etc. It's important to note here that the investments are shown at their cost or market price, whichever is lower. So if the company has done really well with it's investments, the appreciation in value is hidden. Other Long-Term Assets
Any long-term investments that could not specifically be included in any of the line items above gets lumped into other long-term assets. Other Assets, Total
This is a catch-all for assets that do not fall under any of the line items above.
LIABILITIES
Liabilities are what the company owes. Let's look at the different line items that are covered under Liabilities. These can be classified into two main categories — current liabilities and long-term liabilities.
Current Liabilities: These are the short-term debts and obligations that the company must pay within the fiscal year. Where does the money to pay them come from? For the most part, from the conversion of current assets into cash. Accounts Payable:
A company buys raw materials needed for production on credit. The invoice that accompanies this purchase is an account payable. Several other production inputs are also bought on credit. One example is the monthly utility bill. The company might take several days or weeks to pay it's monthly gas and electric bill — another account payable. Accrued Expenses:
These are expenses that the company has incurred, but hasn't got the bill for yet. Examples are salaries, sales tax, rent, etc. that still has to be paid out. Notes Payable/Short-Term Debt:
This is money that the company has borrowed due within a year — short-term bank loans and commercial paper. Long-Term Debt Due:
This covers long-terms debts that are due within the coming year. Depending on the long-term debt structure of the company, this may not be a yearly current liability. Other Liabilities, Total:
A catch-all for all short-term liabilities that couldn't be assigned a specific category above. Total Liabilities:
Sum of all the current liabilities captured above. Long-Term Liabilities: These include liabilities that have to be paid back beyond the current year. They are broken down in to — Long Term Debt:
Companies need to borrow money for long-term projects. All this debt that comes due beyond the current year goes on the long-term liability line in the Balance Sheet. Deferred Income Tax:
Differences between tax laws and accounting methods may result in a difference in the amount of income tax the company has to pay. This difference is recorded as deferred income tax — tax to be paid at a later date. Other Liabilities, Total:
A catch-all for all miscellaneous debt that couldn't find a home under any other liability category. Examples are non-current benefits, interest on tax liabilities, unpaid fines, etc.
SHAREHOLDER'S EQUITY
Shareholder's equity represents the company's net worth. If you subtract the company's liabilities from its assets, you are left with shareholder's equity.
The following are the components of Shareholder's Equity: Preferred Stock:
Preferred stock holders don't have any voting rights but have first claim over dividend, if declared, and the company's assets in the event of a bankruptcy. The amount on this line in the Balance Sheet represents the par (stock has to be at or above a certain minimum value when issued) value of the stock. Common Stock:
Common stock is also carried at its par value. Additional Paid-In Capital:
The difference between how much the company actually sells its preferred and common stock and its par value is captured under additional paid-in capital. Retained Earnings (Accumulated Deficit):
The portion of net income that the company retains to keep the business growing is put under Retained Earnings on the Balance Sheet. This is an accumulated number — you just add every new year's retained earnings to the sum of retained earnings for all previous years. Of course, if a company is losing money, you are likely to see a negative number here — Accumulated Deficit. Treasury Stock - Common:
When a company buys back its own shares, it can do two things — cancel the shares so they don't exist anymore, or, keep them with the intention of reissuing them at a later date. If a company keeps the shares, then it is carried on the balance sheet as Treasury Stock. It's shown as a negative number because it's a reduction in equity. Other Equity, Total:
Another catch-all — any equity item that doesn't fit in any of the above lines goes here. Total Equity:
Adding together all the line items under Shareholder's Equity gives us total equity .... an indication of the net worth of the company.
Summing Up
We've gone into great detail into the Balance Sheet — every line-item has been explained. So, in a nutshell, what is a Balance Sheet? It's a financial snapshot of a company showing us its Assets, Liabilities, and Shareholder's Equity on a particular date. How can a Balance Sheet help us? It can help us answer important questions when selecting companies to invest in .... How much debt a company carries? How much does a company own? Does the company have a history of buying back its own shares? Is the company increasing its Shareholder's Equity over time?
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