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A balance sheet is one of the financial statements of a business.
It includes information about the business’s assets, liabilities, and shareholder capital at the end of a quarter.
It provides important information on what the business owns, and what it owes.
Maintaining and reading a balance sheet is an important part of a founder’s duties. This blog will give you an in-depth understanding of the balance sheet so you can make the best decisions for your business!
What is a Balance Sheet?
A balance sheet is the final financial statement prepared by a business. It includes important information about the business’s assets, liabilities, and capital.
Balance sheets help the founder and finance team of a business understand the business’s performance over a period of time.
It also helps in the creation of certain accounting ratios, which give an in-depth understanding of the various dimensions of the business, like debt and receivables.
Parts of a Balance Sheet
A balance sheet is divided into three overall categories: assets, liabilities and shareholder equity. Each line item under these categories is the position of the business at that particular point in time.
This is how the various amounts are presented on the Balance Sheet:
|Particulars||As at March 31, 2022||As at December 31, 2021|
As you can see, it is not just this quarter’s values that are given, but last quarter’s as well. This is because a balance sheet is a snapshot of the business’s position at a particular point in time, and not over a period of time.
This is why a balance sheet should always be used in comparison to previous periods.
Let us now look at the various parts of a business’s balance sheet in depth.
Everything that a business owns is classified as an asset. These can include cash, machines, computers, desks, chairs; even things we cannot touch, like patents and trademarks.
Assets in the balance sheet are divided into two categories: current assets and non-current assets.
Current Assets are those assets that are very easily liquidated, or converted to cash. Assets are organized under this category in order of most liquid to least liquid. They include:
Cash and cash equivalents
These are the most liquid assets, which already exist as cash.
Cash equivalents include short-term certificates of deposit and treasury bills. They are called “cash equivalents” because they can be converted into cash in a very short time, so they might as well be considered equal to cash.
Businesses with healthy amounts of cash and cash equivalents will be able to meet their short-term debt obligations with ease.
“Short-term debt obligation” here means debt that businesses have to pay off in a short period of time. For example, accounts payable is a short-term loan that businesses take from vendors, which they have to pay off within a few days or a month at most.
Having too much cash and cash equivalents is also not a good thing! This means that the business is not using its resources well. Businesses that have a lot of cash generally choose to make use of the cash by buying up other companies and expanding their offering.
Inventory refers to the stock of goods that a business has at any point of time. This is included under current assets since it is expected to be sold and converted into cash within the coming year.
These are liquid financial instruments that can be easily and quickly converted into cash. Their maturity is usually less than a year, which is why marketable securities are considered to be highly liquid.
Instead of letting liquid cash sit idle in a bank account, businesses might choose to invest this cash into short-term liquid securities. These securities earn a small amount of interest and are also very easily converted back into liquid cash.
Accounts Receivable or Trade Receivables
Accounts Receivable, or Receivables, is the amount that the customers owe to a business.
Sometimes, a business may sell goods or services to customers who may not be able to pay in cash at the time of purchase. Instead, the business will provide these customers with an invoice, expecting to collect the amount owed within a certain period of time, which may be days or a month at most.
Since this amount is also likely to convert into cash within a very short time, it is considered to be liquid.
These assets are those which cannot, or will not be be liquidated – or converted into cash within the next year. They include:
Assets like property, equipment, land are those that the business purchases without the expectation of selling off within a year.
These fixed assets are capital-intensive (which means they are expensive) and are generally used by the business in revenue-generating operations.
For example, a bakery would own bread-baking ovens, which it would include under Fixed Assets as Machinery.
It is important to note that some fixed assets, especially machines and other physical assets, lose value over time and use. This loss in value is called depreciation, and is subtracted from the value of the fixed asset.
Intangible Fixed Assets
These are assets that cannot be touched, i.e., non-physical assets which are still of high value to the company. Some examples are patents, goodwill, and trademarks.
While tangible assets lose value in the form of depreciation, intangible assets losing value is called amortization.
A liability is that which the business owes to outside parties. These can include loans, payables and others.
Like assets, liabilities are also divided into current liabilities and non-current liabilities.
A current liability is something that the business owes to its creditors within a short period of time. This “time” could be one year, or within one cash conversion cycle.
A cash conversion cycle, or an operating cycle is the amount of time it takes for a business to convert its inventory into sales. A healthy business should be measuring this time in days.
Remember the “short-term debt obligations” we mentioned in the cash and cash equivalents section? Current liabilities are exactly those.
A business pays off its current liabilities with cash and cash equivalents.
A few common current liabilities are:
This is the amount that the business owes to its suppliers. Sometimes, the business might purchase goods or services from outside vendors when it is not able to pay with cash at the time of purchase.
In this case, the supplier will draw up an invoice against the sale, and the business will be liable to pay the supplier within a few days, or a month at most.
This is a kind of unsecured, short-term debt instrument used to finance other short-term liabilities like payroll and inventories. They typically mature within a month, and are for smaller denominations than regular bank loans.
Some other current liabilities include: current maturities of long-term debt, dividends payable, interest payable, income taxes owed within the next year, and so on.
Non-current or Long Term Liabilities
Non-current, Long Term or Fixed Liabilities include debt that does not mature within the coming year. These can include long-term loans like any interest and principal on bank loans, deferred tax liability and more.
The reason for assets and liabilities being divided based on their liquidity is to give insight into how well the company is doing both in the coming year and for the year to come.
For example, if a business has a high current liability balance, but very little cash and cash equivalent balance, it means that it will not be able to pay off its debts without taking on more debt.
This is the money that the owners have invested into the business. This is also called the business’s net worth.
Shareholder Equity is an important figure because when compared to other figures like income and debt, it helps determine if business management is doing a good job at investing and spending the business’s capital.
How Do Balance Sheets Work?
Balance sheets follow the basic accounting principle:
Assets = Liabilities + Equity
If this looks like a very simple formula, that’s because it is! It’s quite intuitive as well, if you think about it.
Let’s use an example to understand this.
Razor Bakery takes out a loan of Rs 10 lakh to open more branches in the city.
Now it owes Rs 10 lakh to the bank, which means this loan is a liability in Razor Bakery’s balance sheet.
On the other hand, Razor Bakery now also owns an additional Rs 10 lakh to spend on leasing property and equipment and everything it needs to expand. This means Rs 10 lakh will also be added to its cash and cash equivalents item under current assets!
This double-sided effect of transactions is explained in our Double Entry System of Accounting blog.
Now let’s look at this in terms of our accounting equation.
The value of Assets has increased by Rs 10 lakh.
The value of Liabilities has also increased by Rs 10 lakh.
Therefore, our accounting equation (Assets+10 lakh = Liabilities+10 lakh + Shareholder Capital) remains balanced!
This statement is called a Balance sheet because both sides i.e., assets and liabilities have to remain balanced at the end!
Format of Balance Sheet
There are many different ways a business can present its balance sheet. Regardless of the structure, all balance sheets have the same line items. If you can read and understand one balance sheet, you can read them all!
Here is an example of Razor Bakery’s balance sheet. Try and remember what each line item means!
Unaudited Condensed Consolidated Balance Sheet as of 31st March 2022
(₹ in lakhs)
|Particulars||As of March 31st, 2022||As of December 31st, 2022|
|Cash & Cash Equivalents|
|Property, Plant and Equipment|
|Deferred Tax Liability|
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- Assets: Anything that a business owns is called an asset
- Non-current assets: Items owned by the company likely to stay with it for more than a year.
- Current assets: Items owned by the company that are likely to be encashed within a year.
- Liabilities: Anything that a business owes to someone is called a liability
- Non-current liabilities: Debts that the business has more than one year to repay
- Current liabilities: Debts that the business has to clear within a year’s time
- Total current assets: All current assets added together
- Net assets: Assets minus liabilities
- Shareholder capital: The value of shareholders’ funds invested into the company
What is a balance sheet?
A balance sheet is one of the financial statements prepared by a business. It shows the business's assets, liabilities and shareholder capital.
Why should balance sheets always tally at the end?
A balance sheet should always be balanced. This is because balance sheets follow the basic accounting principle, which is: Assets = Liabilities + Capital. Any transaction made will always have an equal and opposite effect on both sides of the equation.
Why are balance sheets important?
A balance sheet is important to understand the position of a business in the short and long term. It helps determine if the business has borrowed more than it can handle, or if the business has enough cash to spend.
What are the limitations of balance sheets?
Balance sheets provide a static view of a business's financials. It only shows the financial position at a particular point in time and so, to make any sense of its values, it needs to be compared to previous balance sheets.