A balance sheet is a financial statement that communicates the so-called “book value” of an organization. It is nothing but a representation of companies Assets, Liabilities, and Shareholders’ equity as on a given date.
A balance sheet offers internal and external financial analysts a glimpse of how a company is performing in the current period, how it performed during the previous period, and how it is expected to perform in the coming future. This makes a balance sheet of any company or organisation and important tool for various stakeholders be it the employees, investors, or society in general to take important decisions which is impacted directly or indirectly by the said company.
Balance sheets have a simple equation: Assets= Liabilities+ Shareholders Equity
Now we must understand the 3 broad terms used above i.e., Assets, Liabilities and Shareholder’s Equity.
An asset is a resource with economic value that an individualor corporation owns or controls with the expectation that it will provide a future benefit. They are something that may generate cash flow, reduce expenses, or improve sales, regardless of whether it is manufacturing equipment or copy right. Assets can be classified as:
a) Current Assets (Short Term): They are what a company expects to convert into cash within a year’s time, such as cash and cash equivalents, prepaid expenses, inventory, marketable securities, and accounts receivable. Examples are:
- Cash and Cash Equivalents
- Prepaid Expenses
- Marketable securities
- Accounts Receivable
b) Non-Current Assets (Long Term): They are investments that a company does not expect to convert into cash in the short term, such as land, equipment, patents, trademarks, and intellectual property. Examples are:
- Land and property
- Patents and copywrite
- Brand, Goodwill, and Intellectual Property
- Machinery and other equipment to produce goods or perform services
A Liability is something which is owed to a debtor by any Individual, company, or organization. Liabilities can be classified as:
a) Current Liabilities (Short Term): These are usually due within one year and includes trade payable and other accrued expenses.Examples are:
- Rent Payable
- Salary expenses
- Utility Expenses
- Short term loan payable
- Debt financing
- Accounts payable
- Other accrued expenses
- Taxes payable like GST, Income tax
b) Non-Current Liabilities (Long Term):These are usually due after one year and includes loan, bonds, leases, employee benefits payable after one year. Examples are:
- Pension liabilities
- Long term debt
- Provisions for expenses
- Deferred tax liabilities
III. SHAREHOLDER’S EQUITY
Shareholder equity is a company’s net worth, and it is equal to the total amount that would be returned to the shareholders if the company must be liquidated. and all its debts are paid off. Thus, shareholder equity is equal to a company’s total assets minus its total liabilities. Shareholder’s equity is depicted by the following Equation: Shareholder’s equity= Assets- Liabilities
Shareholder’s equity has two components. One which is contributed to the business by shareholders which represent their ownership and second is the retained earnings that a company generates from the fund invested in it by the stakeholders and from its business operations.
THE PURPOSE OF THE BALANCE SHEET
Balance sheets provide a snapshot of how a company is performing and its financial health at any given point of time. Its serves as a source of information for both internal and external users of the organisation to which the balance sheet pertains to.
- Uses to Internal Stakeholders: It is reviewed closely by the top management of the company, its employees, and other key stakeholders. Based on the information provided by its top management can take important future policy decisions or any corrective measures, employees can decide their future in the company and growth prospects.
- Uses to external stakeholders: Balance sheet may be used by eternal stakeholders like investors, auditors, society in general. Since it is based on past performance of the company it is used by investors to decide whether to invest their money into the company and whether it has enough growth opportunities in future to give it returns in the form of dividends, It is used by Auditors to access whether the company is compliant with the applicable laws and used by society in general to determine whether the actions of the company is helping the society get better in terms of employment or growth or adversely impacting it by adding more of pollution and creating more of debt.
SHOULD A BALANCE SHEET ALWAYS BALANCE?
The name itself suggest that a balance sheet should always balance. The total assets side should always be equal to Total Liabilities and Shareholder’s Equity. In real life scenarios may at times we find difficulty in balancing our companies Balance sheets. It may be caused by any one or more than one reasons:
- Incorrect entry of any transaction
- Wrong Journal entry passed
- Incorrect profit calculation or incorrect tax or deferred tax calculation
- Incomplete data entry
- Errors in Currency exchange rates
- Miscalculation of equity
STEPS TO PREPARE A BASIC BALANCE SHEET
Different countries follow different accounting standards to prepare its Balance Sheet. No matter what accounting standard is followed in the preparation of the Balance Sheet one should follow these following simple steps to prepare a Balance Sheet:
- Determine the Reporting Date and Period: A company may operate based on financial year or calendar year. In different countries different financial year basis is followed and based on the country in which a company is operating one must choose its Reporting date and period. For example: In India we follow April to March ended financial year. If a company follows calendar year reporting, then its reporting period will be January to December end and reporting date will be 31st December.
- Identify your assets and liabilities and classify them under proper head based on whether its short term or long term and classification.
- Calculate Shareholder’s Equity: If a company is held privately by single owner, then it is simple to calculate shareholders equity but for a publicly held company the calculation might be complex and include various types of stock issued. Common line items under this section of balance sheet are as follows:
- Common stock
- Preferred stock
- Retained earnings
- Treasury stock
4. Check whether Total Assets is equal to Total Shareholder’s Equity and Total Liability
It is important to note that the balance sheet is formatted according to Reporting standards followed by different countries. For Example, in USA, US local GAAP is accepted for preparing financial statements. Firms in the United Kingdom are compulsorily required to prepare financials as per the local UK and Irish GAAP. Also, based on the development at the global level, UK and Irish GAAP are blended into the IFRS for the global reporting perspectives.In India, financials are to be presented by considering Indian GAAP and acceptable IFRS in line with the global reporting framework.
Schedule III of the Companies Act, 2013 provides guidelines and instructions for the preparation of financial statements, which include the balance sheet, the statement of profit and loss, cash flow statements, notes to accounts or notes to financial statements, and related statements of a company.
Balance sheet format as per Schedule III of the Companies Act, 2013 is as follows:
EXAMPLE OF REAL LIFE BALANCE SHEET
Below is the example of the recent Consolidated Balance sheet of Apple Inc.
The first thing to note in the Balance sheet is that the financial year for reporting of Balance sheet followed by Apple Inc. is October to September. The balance sheet compares the financial position of the company as of September 2022 to the financial position of the company from the prior period.
In the example, Apple Inc’s assets are broadly divided into two broad categories Current and Non-Current Assets which are further sub classified into other categories based on the nature of transactions or assets. Under the category Current Assets the most liquid asset i.e cash and cash equivalents appear first which means that the assets are classified in the order of decreasing level of liquidity. Similar rule of liquidity is followed for sub classification of Non-Current Assets.
This Balance Sheet of Apple also reports liabilities and Equity each with its own section in the lower half of the report. The liabilities section similar to the assets section is divided into Current and Non-Current Liabilities. The total shareholders’ equity section reports Common stock, Retained earnings and accumulated other comprehensive income.
On comparing the Balance Sheet of Apple Inc for the two reporting periods we find that the Cash and Cash equivalents has reduced over the last reporting period and Inventories in hand has also reduced whereas both the trade and non trade receivables has increased.
Company has also increased its investment in plant, property and equipment indicating locking up funds in the Non-Current Assets.
The companies’ accounts payable and other current liabilities have increased as compared to the last reporting period. However the companies’ long term debt has been reduced from the last reporting period.
The Balance Sheet can be used for calculating various financial ratios. The increase or decrease in the balance sheet figures makes more sense when looked as ratios. However these ratios are more meaningful if calculated for two different reporting periods or two different comparative companies. For example, some ratios are calculated below for two different reporting periods:
1. Current Ratio: Current Assets/ Current Liabilities
Current Ratio (2022) = 135,405/153,982 = 0.88
Current Ratio (2021) = 134,836/125,481 = 1.07
Current Ratio tries to measure the short term liquidity of a company. In this case the liquidity has gone down in 2022 compared to 2021.
2. Quick Ratio = (Current Assets- Inventories)/Current Liabilities
Quick Ratio (2022) = ( 135,405 – 4,946)/153,836 = 0.85
Quick Ratio (2021) = (134,836 – 6,580)/125,481 = 1.02
Quick ratio becomes stricter to measure liquidity and removes inventory and then tries to measure short term liquidity. In This case the liquidity has decreased to a great extent.
3. Cash Ratio: (Cash + Marketable Securities)/ Current Liabilities
Cash Ratio (2022) : (23,646 + 24,658)/153,982 = 0.31
Cash Ratio (2021) : (34,940 + 27,699)/125,481 = 0.50
Cash ratio just considers those assets which on a practical basis are the most liquid assets like investments and cash. In this case as well we see that the liquidity position has deteriorated.
4. SOLVENCY RATIO:
- Long term Debt to Equity Ratio: (Lower the Better)= Long term Debt/ Total Equity
Long term Debt to Equity (2022) = 98,959/50,672 = 1.95
Long term Debt to Equity (2021) = 109,106/63,090 = 1.73
The debt-to-equity ratio measures how much debt a company is using to finance its operations. A higher debt-to-equity ratio indicates that a company has higher debt, while a lower debt-to-equity ratio signals fewer debts. Generally, a good debt-to-equity ratio is less than 1.0, while a risky debt-to-equity ratio is greater than 2.0. But this is relative—there are some industries in which companies regularly leverage more debt. The debt-to-equity ratio by itself won’t give you enough information to make an educated investment decision. Still, it can help you determine a company’s financial health and future risk.
- Debt to Assets Ratio: Total Debt/Total Assets
Debt to Assets Ratio (2022) = 98,959/352,755 =0.28
Debt to Assets Ratio (2021) = 109,106/351,002 =0.31
In the given example the Debt to Assets ratio has decreased indicating lower percentage of assets funded by debt in 2022 compared to 2021.
DIFFERENT TYPES OF BALANCE SHEETS
- Classified: The classified formatlists information regarding assets, liability and equity organized into subcategories of accounts.
- Common size:This format includes the same information other sheets have but includes another column that shows the ratio of the total assets, liabilities, and equity line items. It is useful to see the percentages in the trend line, which shows the relative changes in accounts.
- Comparative: This format provides you with a side-by-side comparison of the three sections at multiple times.
- Vertical: In this format, you list all items related to the three main sections of a balance sheet in one column and list line items in decreasing order of liquidity.
ADVANTAGES OF BALANCE SHEET
- Balance Sheets Determine Risk and Return. Investors usually before investing its hard-earned money first have a deep look into the balance of the company. Balance sheet is the reflection of the financial health of the company at any given point of time and helps to determine roughly its future growth prospects.
- It helps compare your business to your competitors. Looking at the balance sheet of two different companies can give a better view of where your company stands in comparison with them in various aspects and how one can improve its ratios to be more competitive in the industry.
- Different ratios can be calculated using balance sheet like liquidity ratio’s (current and quick ratio) and with help of profit & loss account other various solvency, profitability ratios that can help understand the financial standing and health of the company better.
LIMITATIONS OF BALANCE SHEET
- Fixed assets are not shown at their true value in the balance sheet. Fixed assets are shown in the balance sheet at the book value (Historical Cost-Depreciation). They do not show the true market value of the asset.
- Balance sheets do not reflect the value of certain factors that are crucial to companies’ sustainability and growth and are like assets (e.g., skill and loyalty of the staff).
- The value of most current assets depends on some estimates, so it cannot reflect the true financial position of the business.
- Since they are prepared using different Reporting standards and accounting policies, at times their comparison with a different company in the same industry becomes difficult.
- Since Balance sheet is prepared using the past data it sometimes may not provide the true picture of how the company may look like a few years down the line.