Have you ever wondered how investors and other interested parties assess the financial position of companies before they become shareholders?
Alternatively, how do shareholders make informed decisions regarding a company? Parties interested in a company carry out a financial statement analysis to make these decisions. An analysis of financial statements would include a study of the Balance Sheet, Income Statement, and Cash Flow Statement.
A balance sheet is often referred to as a statement of financial position and helps declare the assets, liabilities, and shareholder equities related to the company. This allows the investors to calculate the rates of return while providing an insight into the financial structure of a company.
The balance sheet of a company highlights its finances on a given date in terms of what the company owns and owes. Fundamental analysis of a balance sheet facilitates the calculation of several financial ratios, including the debt-to-equity ratio.
A regular balance sheet format comprises Assets on one side, with Liabilities and Shareholder Equity on the other. For better understanding, one can state that the balance sheet aims to establish a simple accounting equation, which balances out the components mentioned above:
Assets= Liabilities + Shareholders’ Equity
This formula can be understood with a little clarification. Whatever a company owns, is labeled as an asset. However, to pay for these assets, the company can borrow money, which adds to the liabilities.
The company can also allow third parties to invest, adding to the shareholder equity. One can guess that to maintain a healthy capital structure, both sides of the equation need to be balanced.
This can be explained with a scenario, in which a small business takes out a $10,000 loan from a local bank, which will add to the assets, as the $10,000 go to the cash account.
However, at the same time, the liabilities section also incurs an increase of $10,000 as the long-term debt account is equally affected by the transaction.
Components of a Balance Sheet
If simplified for better understanding, it can refer to everything that the company owns or is capable of generating cash. The accounts that are listed on this side of a balance sheet are arranged in decreasing order of liquidity, or ease of conversion into cash. The accounts that come under current assets are of several types, based on their ease of liquefaction.
Assets of a company can be ranked based on liquidity as follows:
- Cash and Cash Equivalents include assets, which can be liquefied with ease, such as certificates of deposit, hard currency, and bills related to the treasury.
- Marketable Securities include debts as well as equity, which hold a liquid market.
- Accounts Receivable refers to the money owed by customers to the company and includes bad debts and risky accounts.
- Inventory held by a company refers to the goods or services that it can provide in exchange for currency.
- Long-term assets include securities that cannot be liquidated within a year, land, machinery, and equipment among other capital-intensive assets. Long-term Assets also include goodwill and intellectual property when acquired by the company.
Liabilities refer to the money that the company owes to third parties, and they include:
- Money in the form of bills that are due for payment, or interest to be paid to creditors, utilities, and rent availed by a company.
- Depreciation expenses include assets subject to gradual depreciation. These expenses include Cars, outdated Technology, and other expenditures that are of use to a company but lose value over time.
- Bank Indebtedness
- Pension funds fall in liabilities. It is so because it requires the company to deposit money into the retirement accounts of its employees.
3. Shareholder Equity:
Shareholder Equity falls on the right-hand side of the equation and equals the total assets that a company owns minus its liabilities. Thus, you can say that one can derive shareholder equity by subtracting the liabilities and debts owed to third parties that are not shareholders from its total assets.
The balance sheet represents the financial structure of a company at an instant and it can be compared with a balance sheet from another instance in the past. To overcome the limitations of balance sheets, analysts often refer to cash flow statements and income statements.
How to Make a Balance Sheet
Once you have developed a basic concept of what a Balance Sheet is and how it relates to other Financial Statements, we can move on to the process of making a balance sheet, which includes five steps:
1. Picking a date
Select a specific date to assess and estimate the value of current assets, liabilities, and equity of shareholders.
2. Listing and summation of Assets
The assets available to the company on a particular date are arranged based on their liquidity. Both Current and Non-Current assets belong in this list. The values of these assets are summed up and labeled as total assets.
3. Listing and summing up liabilities
Current liabilities due to be settled within a year are along with several long-term liabilities. One must sum up all the current and non-current liabilities.
4. Calculate the equity of owners
To do this, one must determine the retained earnings of a company in addition to the working capital. Retained earnings can refer to the profit made by a company, kept aside for reinvestment. Therefore, adding up share capital and retained earnings lead us to the Shareholders’ equity.
5. Establishing the balance sheet equation
In addition, if the equation “Assets= Liabilities + Shareholders’ Equity” is validated, you have made an accurate balance sheet. Upon failure, one can always go back and review their process and calculations.
Why should you check your balance sheets regularly?
Businesses can benefit from Balance Sheets that represent their financial standings in front of investors, other stakeholders, and lenders. It can provide you with information regarding what a business owns and owes to others.
A balance sheet can allow you to make more informed decisions, which helps sustain and grow the business.
A balance sheet can provide information regarding the assets and liabilities of a company, therefore estimating its profitability.
In an ideal condition, the Assets must outweigh the Liabilities and Stockholders’ Equity. The Balance sheet can provide your business with an accurate representation of its current economic standings, which can make it easier to secure business loans, as well as other capital. The balance sheet also helps obtain important ratios regarding liquidity, the profitability of a business, and its solvency.
Your business can only benefit from a balance sheet as it paints a complete picture of the capital structure of a company, combined with other financial statements. An accurate analysis of the assets and liabilities of a company can help better management of resources as well as funds within a company. Frequent revisions of balance sheets help companies stay out of debt while they sustain and grow a healthy business.
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