A balance sheet provides an overview of a company’s financial condition
A balance sheet, also known as the financial position statement, depicts a company's financial balance in terms of assets and liabilities/equity. As opposed to an income statement, the balance sheet can be seen as a snapshot of a business's situation since it shows the company’s financial situation at a specific point in time. As a result, it does not allow conclusions about a company’s performance over a time period but rather its status at a specific time point.
Equity and liabilities on one side and assets on the other side must be balanced (Equity + Liabilities = Assets)
A balance sheet consists of two sides: assets and equity/liabilities. As you can guess by the name, both sides should be balanced.
- On the one side, the balance sheet lists the value of all assets a company owns. These can be tangible (such as cash, receivables, and goods) or intangible (such as brand value or patents). They are sorted in terms of their liquidity, which is the ease of selling them in order to generate cash. Current assets are very liquid while long-term assets, or fixed assets, are less liquid.
- On the other side, the balance sheet shows how assets of a company are financed, meaning how assets were acquired. They are either financed through equity, which is the company owner’s money, or they are financed by debt, which are liabilities the company owes to others.
Find below an example of a typical balance sheet
Together with the Cash Flow Statement and Income Statement, the financial position is analyzed to derive an overview of a firm's (financial) situation. Key ratios structure the data to compare the firm with similar competitors and provide a quick overview for analysts (see benchmarking).
Analyze the balance sheet to gather critical insights
If you are given details from a balance sheet during your case, you can interpret the different components. Especially if you look at the development of certain figures or ratios by comparing data from previous years, you can generate useful insights.
- Cash: Usually, an increasing amount of cash is an indication of good performance and growth. Cash reserves secure a company against recessions and can be used as funds for investments. Too much cash, on the other hand, is suspicious: It might be a result of extraordinary sales or it is a sign of a firm’s difficulties to find appropriate investments.
- Inventory: Large amount of inventories cause storage costs. Money is tied up in products, which could be used otherwise for investments (see opportunity costs). Growing inventory is often a sign of either decreasing sales or overcapacity in production.
- Receivables: The faster the firm collects money tied up in receivables the better, as cash as opposed to receivables can be invested or at least generate interest. Furthermore, early collecting of receivables decreases the default risk of single customers. Increasing receivables can be a sign of more sales, but also delayed payments from customers.
- Includes all assets which are not current, such as real estate and intangible assets. Companies cannot sell their fixed assets quickly. They are long-term investments necessary to run a business. The extent of non-current assets, therefore, depends highly on the industry. It can be useful to check if the investments in fixed assets are really business-relevant or serve other purposes.
- Current Liabilities are obligations, such as payments to suppliers. They must be paid within a short time frame. In the regular case, large current liabilities are not a problem as it is an advantage for a company if they are allowed to pay their bills late. However, in case of financial distress, increasing liabilities can become a problem.
- Non-current liabilities are usually credits and loans given by banks or bondholders. They can be both advantageous and problematic. Usually, debts are cheaper capital since interest paid for them is less than what a company pays to equity holders. Interests reduce the earnings a company generates and thus the taxes it has to pay. However, if debts and interest are too high, a company might run bankrupt if they cannot pay interest. In addition, large debt amounts increase the dependency on the general development of key interest rates.
Equity is owned by shareholders. All Assets not owned by creditors via obligations belong to shareholders. Therefore Equity = Total Assets – Total Liabilities
- Capital stock represents the money investors give when they buy shares from the company for the first time.
- Retained earnings depict the earnings a company put aside from previous profits. A company can either distribute those earnings to its shareholders via dividends or keep them as retained earnings.
Calculate some common ratios to compare the company with the competition
Liquidity ratios provide information about a firm’s ability to repay debts. The Cash Ratio shows to what extent a company’s cash and quickly sellable securities are sufficient to repay the debt. If the ratio is less than 1, there is not enough cash to repay all liabilities due in one year.
The Quick Ratio and Working Capital work similarly, however, more illiquid assets are included in these ratios:
Debt Ratios show a company’s extent of debts. The debt ratio gives the percentage of assets that are financed by debt. Leverage compares Liabilities and Equity directly but has basically the same meaning.
The Price to Book Ratio shows if a company is under or overvalued. The market value of a firm is the amount of outstanding shares times the price per share. Therefore, it mirrors the market’s opinion about the equity value. If the Price to Book Ratio is larger than one, the market values the company more than it is worth according to the balance sheet. The company might be overvalued unless other factors compensate for that (e.g., vast growth, customer loyalty, brand strength, etc).
- A balance sheet provides an overview of the financial situation of a company on the reporting date.
- It lists the assets and how they are financed.