Balance Sheet: Explanation, Components, and Examples

What Is a Balance Sheet?

A balance sheet reports various assets, liabilities, and sources of owners’ equity. Cash is a very important asset, but other assets are equally important as well, including trade account receivables; inventory; property, plant, and equipment; intangible assets; and company investments.

The balance sheet provides a basis for calculating returns and evaluating the capital structure of a company. It shows the amount invested by shareholders, as well as the amount owed by the company.

The balance sheet is unlike the income and cash flow statements, which report flows over a period of time (such as sales revenue which is the cumulative amount of all sales during the period). The balance sheet presents the balances (amounts) of a company’s assets, liabilities, and owners’ equity at an instant in time. 

Notice the two quite different meanings of the term balance. As used in the balance sheet, the term refers to the equality of the two opposing sides of a business — total assets on the one side and total liabilities and owners’ equity on the other side, like a scale. 

In contrast, the balance of an account (asset, liability, owners’ equity, revenue, and expense) refers to the amount in the account after recording increases and decreases in the account — the net amount after all additions and subtractions have been entered. Usually, the meaning of the term is clear in context.

How Balance Sheets Work

The balance sheet shows what a company’s assets are (what it owns), what its liabilities are (what it owes), and what its equity is (what’s left over) at a specific point in time.

To start, there are three principal components of a balance sheet. The first, assets, is things that are owned. There are many types of assets. Assets that are readily converted into or used as cash are deemed short-term in nature. Examples of short-term, or current, assets are cash, monies due from customers (called “accounts receivable”), inventory (stocked items for sale), or any other owned items that are expected to be liquidated or used as cash within one year from the date on the balance sheet.

Assets such as real estate, furniture, or equipment used to operate the business are generally not expected to be sold within 12 months. Consequently, these owned items are classified as long-term in nature. Long-term assets maintain their value over an extended time frame based on their estimated useful lives. A building, for example, will not decline in value as quickly as a computer, and less of its cost is lost each year as a result.

On the other side of the ledger, a company that owns assets typically also owes money to various people or entities in the form of liabilities. Liabilities are simply IOUs. A business or individual might owe money to employees in the form of accrued payroll or vacation time, to vendors (suppliers who have shipped products or provided services with the expectation of payment in 30 or 60 days, called “accounts payable”), to banks in the form of credit cards or other debt, to the Internal Revenue Service, or to other creditors. Those debts that must be paid within a year from the balance sheet’s date are considered short-term liabilities. Obligations that needn’t be paid for at least 12 months are deemed long-term liabilities.

The difference between assets and liabilities is called “net worth,” or equity. In short, if you were to sell the assets shown on a balance sheet at their listed values and use the proceeds to pay off the stated liabilities, whatever is left would be considered equity. Equity is the value the owners have in the business.

Similarly, an individual might sell his or her possessions, satisfy all creditors with the proceeds, and keep whatever is left over for himself or herself. Keep in mind that it is possible to have negative equity if the proposed asset sales wouldn’t result in enough cash to pay off the listed liabilities. 

Let’s look at an easy example. Imagine buying a house for $100,000, with a $10,000 down payment and a $90,000 mortgage. You’ve just created a balance sheet. A $100,000 asset (the house) equals the $90,000 liability (the mortgage) plus $10,000 in equity (also called “net worth”). In other words, if you sell the asset and use the proceeds to pay off the liabilities, you get net worth, or equity.

Of course, companies (and individuals) have assets of varying kinds in addition to real estate. These include cash, inventory, equipment, and patents. We owe money in forms other than mortgages, such as taxes, utility bills, credit cards, and payroll. Net worth, or equity, is calculated by subtracting total liabilities from total assets. It’s simple.

The Balance Sheet Formula

A company keeps track of its financial balance on a balance sheet, a summary of the company’s financial standing at a particular point in time. To understand balance sheets, you first have to understand the following terms, which typically appear on a balance sheet:

  • Assets: Anything the company owns, from cash, to inventory, to the paper on which it prints the reports
  • Liabilities: Debts the company owes
  • Equity: Claims made by the company’s owners, such as shares of stock

The assets a company owns are equal to the claims against that company by either debtors (liability) or owners (equity). The claims side must equal the assets side for the balance sheet to stay in balance. The parts always balance according to this formula:

Assets = Liabilities + Equity

As a company and its assets grow, its liabilities and equities grow in similar proportion. Whenever a company buys a major asset, such as a building, it has to use another asset to pay for the building or use a combination of assets and liabilities (such as bonds or a mortgage) or equity (owners’ money or outstanding shares of stock).

Components of a Balance Sheet

Assets

Anything a company owns is considered to be an asset. Assets can include something as basic as cash or as massive as a factory. A company must have assets to operate the business. The asset side of a balance sheet gives you a summary of what the company owns.

Current assets

Anything a company owns that it can convert to cash in less than a year is a current asset. Without these funds, the company wouldn’t be able to pay its bills and would have to close its doors. Cash, of course, is an important component of this part of the balance sheet, but a company uses other assets during the year to pay the bills.

  • Cash: For companies, cash is basically the same as what you carry around in your pocket or keep in your checking and savings accounts. Keeping track of the money is a lot more complex for companies, however, because they usually keep it in many locations. Every multimillion-dollar corporation has numerous locations, and every location needs cash.
  • Marketable securities: Marketable securities are types of liquid asset, which means that they can easily be converted to cash. They include holdings such as stocks, bonds, and other securities that are bought and sold daily. Securities that a company buys primarily as a place to hold on to assets until the company decides how to use the money for its operations or growth are considered to be trading securities. Marketable securities held as current assets fit into this category. A company must report these assets at their fair value based on the market value of the stock or bond on the day the company prepares its financial report.
  • Inventory: Any products a company holds ready for sale are considered to be inventory. The inventory on the balance sheet is valued at the cost to the company, not the price at which the company hopes to sell the product. Companies can choose among five methods to track inventory, and the method they choose can significantly affect the bottom line.
  • Long-term assets: Assets that a company plans to hold for more than one year belong in the long-term assets section of the balance sheet. Long-term assets include land and buildings; capitalized leases; leasehold improvements; machinery and equipment; furniture and fixtures; tools, dies, and molds; intangible assets; and others. This section of the balance sheet shows you the assets that a company has to build its products and sell its goods.
  • Land and buildings: Companies list any buildings they own on the balance sheet’s land and buildings line. Companies must depreciate (show that the asset is gradually being used up by deducting a portion of its value) the value of their buildings each year, but the land portion of ownership isn’t depreciated. The IRS allows 39 years for the depreciation of a building; after that time, the building is considered to be valueless.
  • Capitalized leases: Whenever a company takes possession of or constructs a building by using a lease agreement that contains an option to purchase that property at some point in the future, you see a line item on the balance sheet called capitalized leases. It means that at some point in the future, the company may likely own the property and then can add the property’s value to its total assets owned. You can usually find a full explanation of the lease agreement in the notes to the financial statements.
  • Leasehold improvements: Companies track improvements to property that they lease and don’t own in the leasehold improvements account on the balance sheet. These items are depreciated because the improvements will likely lose value as they age.
  • Machinery and equipment: Companies track and summarize all machinery and equipment used in their facilities or by their employees in the Machinery and Equipment accounts on the balance sheet. These assets depreciate just like buildings but for shorter periods, depending on the company’s estimate of their useful life.
  • Furniture and fixtures: Some companies have a line item for furniture and fixtures, whereas others group these items in machinery and equipment or other assets. You’re more likely to find furniture and fixture line items on the balance sheet of major retail chains that hold significant furniture and fixture assets in their retail outlets than on the balance sheet for manufacturing companies that don’t have retail outlets.
  • Tools, dies, and molds: You find tools, dies, and molds on the balance sheet of manufacturing companies, but not on the balance sheet of businesses that don’t manufacture their own products. Tools, dies, and molds that are unique and are developed specifically by or for a company can have significant value. This value is amortized, which is similar to the depreciation of other tangible assets.

Intangible assets

Any assets that aren’t physical — such as patents, copyrights, trademarks, and goodwill — are considered to be intangible. Patents, copyrights, and trademarks are registered with the government, and a company holds exclusive rights to these items. If another company wants to use something that’s patented, copyrighted, or trademarked, it must pay a fee to use that asset.

Patents give companies the right to dominate the market for a particular product. Pharmaceutical companies can be the sole source for a drug that’s still under patent, for example. Copyrights also give companies exclusive rights for sale. Copyrighted books can be printed only by the publisher or person who owns that copyright, or by someone who has bought the rights from the copyright owner.

Goodwill is a different type of asset, reflecting the value of a company’s locations, customer base, or consumer loyalty, for example. Firms essentially purchase goodwill when they buy another company for a price that’s higher than the value of the company’s tangible assets or market value. The premium that’s paid for the company is kept in an account called Goodwill that’s shown on the balance sheet.

Other assets

Other assets is a catch-all line item for items that don’t fit into one of the balance sheet’s other asset categories. The items shown in this category vary by company; some firms group both tangible and intangible assets here.

Other companies may put unconsolidated subsidiaries or affiliates in this category. Whenever a company owns less than a controlling share of another company (less than 50 percent) but more than 20 percent, it must list the ownership as an unconsolidated subsidiary (a subsidiary that’s partially but not fully owned) or an affiliate (a company that’s associated with the corporation but not fully owned).

Ownership of less than 20 percent of another company’s stock is tracked as a marketable security (see “Marketable securities” earlier in this chapter). Long before a firm reaches even the 20 percent mark, you usually find discussion of its buying habits in the financial press or in analysts’ reports. Talk of a possible merger or acquisition often begins when a company reaches the 20 percent mark.

You usually don’t find more than a line item that totals all unconsolidated subsidiaries or affiliates. Sometimes, the notes to the financial statements or the management’s discussion and analysis sections mention more detail, but you often can’t tell by reading the financial reports and looking at this category what other businesses the company owns. You have to read the financial press or analyst reports to find out the details.

Accumulated Depreciation

On a balance sheet, you may see numerous line items that start with accumulated depreciation. These line items appear under the type of asset whose value is being depreciated or shown as a total at the bottom of long-term assets. Accumulated depreciation is the total amount depreciated against tangible assets over the life span of the assets shown on the balance sheet.

Although some companies show accumulated depreciation under each of the long-term assets, it’s becoming common for companies to total accumulated depreciation at the bottom of the balance sheet’s long-term assets section. This method of reporting makes it harder for you to determine the actual age of the assets because depreciation isn’t indicated by each type of asset. You have no idea which assets have depreciated the most — in other words, which ones are the oldest.

The age of machinery and factories can be a significant factor in trying to determine a company’s future cost and growth prospects. A firm with mostly aging plants needs to spend more money on repair or replacement than a company that has mostly new facilities. Look for coverage of this topic in the management’s discussion and analysis or the notes to the financial statements. If you don’t find this information there, you have to dig deeper by reading analyst reports or reports in the financial press.

Liabilities

Companies must spend money to conduct their day-to-day operations. Whenever a company makes a commitment to spend money on credit, be it short-term credit via a credit card or long-term credit via a mortgage, that commitment becomes a debt or liability.

Current liabilities

Current liabilities are any obligations that a company must pay during the next 12 months, including short-term borrowings, the current portion of long-term debt, accounts payable, and accrued liabilities. If a company can’t pay these bills, it may go into bankruptcy or out of business.

  • Short-term borrowings: Short-term borrowings usually are lines of credit a company that takes to manage cash flow. A company that borrows this way isn’t much different from how you may use a credit card or personal loan to pay bills until your next paycheck. As you know, these types of loans usually carry the highest interest-rate charges, so if a firm can’t repay them quickly, it converts the debt to something longer-term with lower interest rates.
  • Current portion of long-term debt: This line item of the balance sheet shows payments due on long-term debt during the current fiscal year. The long-term-liabilities section reflects any portion of the debt that a company owes beyond the current 12 months.
  • Accounts payable: Companies list money that they owe to others for products, services, supplies, and other short-term needs (invoices due in less than 12 months) in accounts payable. They record payments due to vendors, suppliers, contractors, and other companies they do business with.
  • Accrued liabilities: Liabilities that a company has accrued but hasn’t yet paid at the time it prepares the balance sheet are totaled in accrued liabilities. Companies include income taxes, royalties, advertising, payroll, management incentives, and employee taxes that they haven’t yet paid in this line item. Sometimes, a firm breaks out items individually, such as income taxes payable, without using a catch-all line item called accrued liabilities. When you look in the notes, you see more details about the types of financial obligations included and the total of each type of liability.

Long-term liabilities

Any money a business must pay out for more than 12 months in the future is considered to be a long-term liability. Long-term liabilities don’t throw a company into bankruptcy, but if they become too large, the company may have trouble paying its bills in the future.

Many companies keep the long-term liabilities section short and sweet, grouping almost everything under one category such as long-term debt. Long-term debt includes mortgages on buildings, loans on machinery or equipment, or bonds the company needs to repay at some point in the future. Other companies break out the type of debt, showing mortgages payable, loans payable, and bonds payable.

Readers must dig through the notes and management’s discussion and analysis to find more details about the liabilities.

Shareholder Equity

The final piece of the balancing equation is equity. All companies are owned by somebody, and the claims that owners have against the assets the company owns are called equity. In a small company, the equity owners are individuals or partners. In a corporation, the equity owners are shareholders.

Stock

Stock represents a portion of ownership in a company. Each share of stock has a certain value, based on the price placed on the stock when it’s originally sold to investors. The current market value of the stock doesn’t affect this price; any increase in the stock’s value after its initial offering to the public isn’t reflected here. The market gains or losses are actually taken by the shareholders, not the company, when the stock is bought and sold on the market.

Some companies issue two types of stock:

  • Common stock: These shareholders own a portion of the company and have a vote on issues. If the board decides to pay dividends (a certain portion per share it pays to common shareholders from profits), common shareholders get their portion of those dividends as long as the preferred shareholders have been paid in full.
  • Preferred stock: These shareholders own stock that’s actually somewhere in between common stock and a bond (a long-term liability to be paid back over years). Although they don’t get back the principal they pay for the stock, as a bondholder does, these shareholders have first dibs on any dividends. Preferred shareholders are guaranteed a certain dividend each year. If a company doesn’t pay dividends for some reason, it accrues these dividends for future years and pays them when it has enough money. A company must pay preferred shareholders their accrued dividends before it pays any money to common shareholders. The disadvantage for preferred shareholders is that they have no voting rights in the company.

You may also find Treasury stock in the equity section of the balance sheet. This is stock that the company has bought back from shareholders. Many companies did that in 2018 after the new tax law took effect, so look for that on balance sheets. When a company buys back stock, it means that fewer shares are on the market. When fewer shares are available for purchase on the open market, stock prices tend to rise.

If a firm goes bankrupt, the bondholders hold first claim on any money remaining after the company pays the employees and secured debtors (debtors who loaned money based on specific assets, such as a mortgage on a building). The preferred shareholders are next in line; the common shareholders are at the bottom of the heap and are frequently left with valueless stock.

Retained earnings

Each year, companies make a choice to pay out their net profit to their shareholders or retain all or some of the profit for reinvesting in the company. Any profit that a company doesn’t pay to shareholders over the years accumulates in an account called retained earnings.

Capital

You don’t find this line item on a corporation’s financial statement, but you’ll likely find it on the balance sheet of a small company that isn’t publicly owned. Capital is the money that the company’s founders initially invested.

If you don’t see this line item on the balance sheet of a small, privately owned company, the owners likely didn’t invest their own capital to get started, or they took out their initial capital when the company began to earn money.

Drawing

Drawing is another line item that you don’t see on a corporation’s financial statement. Only unincorporated businesses have a drawing account. This line item tracks money that the owners take out from the yearly profits of a business. After a company is incorporated, owners can take money as salary or dividends, but not on a drawing account.

Balance Sheet Format

Balance sheets come in three formats: account, report, and financial position. The following figures show samples of these formats, using simple numbers to give you an idea of what you can expect to see. Real balance sheets have much larger and more complex numbers, of course.

Account Format

The account format is a horizontal presentation of the numbers. A balanced sheet shows total assets equal to total liabilities/equity.

Report Format

The report format is a vertical presentation of the numbers.

Financial Position Format

American companies rarely use the financial position format, although it’s common internationally, especially in Europe. The key difference between this format and the other two is that it has two lines that don’t appear in the account and report formats:

  • Working capital: This line indicates the current assets the company has available to pay bills. You find the working capital by subtracting the current assets from the current liabilities.
  • Net assets: This line shows what’s left for the company’s owners after all liabilities have been subtracted from total assets.

As investing becomes more globalized, you may start comparing U.S. companies with foreign companies. Or perhaps you’re considering buying stock directly in European or other foreign companies. You need to become more familiar with the financial position format if you want to read reports from foreign companies.

Importance of a Balance Sheet

Is your financial condition viable and sustainable to continue your profit-making endeavor? The balance sheet helps answer this critical question. Perhaps you’re on the edge of going bankrupt, even though you’re making a profit. Your balance sheet is where to look for telltale information about possible financial troubles.

In reading through a balance sheet, you may notice that it doesn’t have a punchline as the income statement does. The income statement’s punchline is the net income line, which is rarely humorous to the business itself but can cause some snickers among analysts. (Earnings per share is also very important for public corporations.) You can’t look at just one item on the balance sheet, murmur an appreciative “ah-ha,” and rush home to watch the game. You have to read the whole thing (sigh) and make comparisons among the items.

The balance sheet lists all of a company’s assets and liabilities. A company can quickly determine if it has borrowed too much money, if its assets are not liquid enough, or if it has enough cash to meet current needs.

Balance sheets are also used to raise capital. By comparing debt to equity on the balance sheet, one can determine whether there is a dangerous level of borrowing. If you want to know if an extension of additional credit will result in bad debt, this information is especially useful for lenders and creditors.

A balance sheet is usually required by a lender to obtain a business loan. When a company seeks private equity financing, it is usually required to provide a balance sheet to private investors. In both cases, the outside party wants to assess the company’s financial health, creditworthiness, and ability to repay short-term debt.

Managers can use financial ratios to measure a company’s liquidity, profitability, solvency, and cadence (sales), and some financial ratios require numbers from the balance sheet. Managers can better understand how to improve a company’s financial health by analyzing it over time or in comparison to competing companies.

Finally, balance sheets can be used to attract and retain talent. Employees typically want to know that their jobs are secure and that the company they work for is healthy. For publicly traded companies that are required to disclose their balance sheets, this requirement allows employees to assess how much cash the company has on hand, whether the company has sound debt management practices, and whether the company’s financial health is consistent with what they expect from their employer.

Example of a Balance Sheet

Below is a portion of ExxonMobil Corporation’s (XOM) balance sheet for fiscal-year 2021, reported as of Dec. 31, 2021.

  • Total assets were $338.9 billion.
  • Total liabilities were $163.2 billion.
  • Total equity was $175.7 billion.
  • Total liabilities and equity were $338.9 billion, which equals the total assets for the period.

Who Prepares the Balance Sheet?

Depending on the company, different parties may prepare the balance sheet. In a small privately held business, the balance sheet might be prepared by the owner or by the company bookkeeper. For mid-sized private companies, an external accountant may review them after they have been prepared internally.

Public companies, on the other hand, are subject to external audits by public accountants, and bookkeeping standards are much higher.

The Securities and Exchange Commission (SEC) requires these companies to prepare balance sheets and other financial statements in accordance with Generally Accepted Accounting Principles (GAAP).

An accountant can prepare a balance sheet at any time that a manager wants to know how things stand financially. Some businesses — particularly financial institutions such as banks, mutual funds, and securities brokers — need balance sheets at the end of each day in order to track their day-to-day financial situation. 

For most businesses, however, balance sheets are prepared only at the end of each month, quarter, or year. A balance sheet is always prepared at the close of business on the last day of the profit period. In other words, the balance sheet should be in sync with the income statement.

What Are the Uses of a Balance Sheet?

A balance sheet shows how a business operates. It provides insight into how much and how a business generates revenues, what the cost of doing business is, how efficiently it manages its cash, and what its assets and liabilities are. There are lots you can understand from a balance sheet. 

First, look at the assets (what the company owns). Assets have a complicated definition in the financial accounting handbook but essentially assets are what generate future income for the business. A company purchases, or holds, assets in the hope that they will produce more income than they cost to buy or hold. 

Next, look at the liabilities (what the company owes). Again, there is a complicated definition for liabilities in the handbook, but generally what it refers to are the obligations that lead to outflows of currency at later date(s) to satisfy these same obligations. In short, you can think of them as simply the debts of the business. 

These debts can represent how you funded the assets on the other side of the balance sheet (note: you can also fund them through equity). For instance, you took on a bank loan of $100,000 (a liability) to purchase a retail shop for a business (an asset in the property, plant, and equipment line item). And then this asset will hopefully lead to income in the future. 

The final section is equity. The better way to look at equity is to think of it as what is left for the owners of the business if all the assets were liquidated and the liabilities paid off. Equity represents owner, or shareholder, funds that have been invested or retained, in the business (although this is not the exact definition). 

Similar to liabilities, equity can also be a source of funds to pay for assets. So rather than taking out that bank loan to buy the retail shop, the business could sell stock/shares in the business and then buy the shop, or simply use the funds, it has earned in business operations (as these ‘Retained Earnings’ are also equity). 

Let’s put it all together in a timeline: 

  1. A business is incorporated and starts its life 
  2. It raises money by taking on liabilities or issuing equity 
  3. It uses this money to buy assets 
  4. The assets generate income 
  5. The income can pay for more assets or the cycle repeats from the stage (2) 

But outside of this timeline, never forget that any balance sheet simply shows a snapshot in time of what a business: 

  • “Owns” (assets) 
  • “Owes” (liabilities) 
  • “What is left for the owners of the business” (equity) 

If you can remember this then you can start to paint a picture of the business. For instance, you can tell how the management likes to finance the business (does it have higher liabilities or higher equity), you can look at line items and see how the assets are structured (e.g. does it have lots of cash or lots of fixed, non-current assets), whether the business is over-leveraged (are liabilities too high in relation to assets), etc. 

These are just a few examples, just think about what the components of the balance sheet represent, spend time analyzing the overall figures and relationships and start to paint that picture of what is going on underneath all those raw numbers.

Limitations of a Balance Sheet

The way in which assets are supported or financed by an increase in liabilities, debt, and equity says a lot about the financial health of a company. For now, suffice it to say that, depending on the industry and industry characteristics, a reasonable ratio of liabilities to equity is a sign of a financially healthy company.

Although this is a highly simplified view of the fundamental accounting equation, investors should consider a much higher value of equity relative to liabilities as a measure of positive investment quality, as high debt can increase the likelihood that a company will go bankrupt.

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