Balance Sheet - Explained
What is a Balance Sheet?
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Table of ContentsWhat is the Balance Sheet?How is a Balance Sheet Used?What Does the Balance Sheet Tell You?AssetsCurrent AssetsNon-current Assets (Long-term Assets)LiabilitiesCurrent LiabilitiesLong-term LiabilitiesShareholders' EquityLimitations of Balance SheetsAcademic Research on Balance Sheet
What is the Balance Sheet?
A balance sheet is a report or statement containing all the assets, liabilities and shareholders' equity owned by a business at a specific time. Balance sheet is important in financial accounting, it is the financial statement that contains the details of a company's asset, equity and liabilities over a period of time time. This statement is also helpful in gaining insights to the capital structure of a business. Business, whether corporations, private limited company, sole proprietorship or business partnership must have balance sheets. This financial statement reveals the income and expenditure is the business of what the business owns and owes over a period of time.
Back to: ACCOUNTING, TAX, & REPORTING
How is a Balance Sheet Used?
Typically, a balance sheet follows this pattern; Assets = Liabilities + Shareholders Equity The balance sheet reveals the assets owned by a company and liabilities owed by the same company. Assets, liabilities and shareholders equity are crucial in the finance of every company and this is why they are reported in the balance sheet. A balance sheet is also the statement of financial position of a company and it is used alongside other statements to carry out a financial analysis of the business.
What Does the Balance Sheet Tell You?
A balance sheet is simply a highlight of the financial condition of a company at a specific time. It is the financial statement that reflects the company's finances, the assets owned, liabilities owed and the amount of shareholders equity. A balance sheet only reports a specific period, it could be a year. Hence, to determine the financial trends in a company over an elongated period, previous balance sheets must come into the picture. Also, the balance sheet of a company could be compared to that of other companies in the same industry to gauge the financial performance and health of the company. Investors who seek have a snapshot into how financially healthy a company is, can do so through the balance sheet. Here are some important things to note about a balance sheet;
- A balance sheet reports the assets, liabilities and shareholders equity of a business for a specific period.
- The balance sheet alongside the income statement and statement of cash flows are the three financial statements needed for the evaluation of a business.
- A company's balance sheet reveals what the company owns and owes.
- Through the balance sheet, how healthy a business is can be determined.
- The balance sheet is an important element in the calculation of financial ratios.
There are two broad categories of assets, these are current assets and non-current assets. Current assets can be converted into cash in a year or less than year. Non-current assets cannot be converted into cash within a short period of time, they are long-term assets. Below is a breakdown of accounts under current assets and those under non-current assets.
- Cash and cash equivalents (hard currency, treasury bills and others.)
- Inventory (goods available for sale)
- Prepaid expenses such as rent and insurance.
- Marketable securities.
- Accounts receivable (cash that customers owe the company.)
Non-current Assets (Long-term Assets)
- Fixed assets such as machinery, land and buildings.
- Intangible assets (trademark, goodwill and intellectual property).
- Long-term investments.
Liabilities in a company's balance sheet comprises of the money it owes to outsiders such as money to be paid to vendors and suppliers, salaries, rent, utilities and money it owes creditors. There are two categories of liabilities, these are;
- Current liabilities, and
- Long-term liabilities.
While current liabilities are those due within a year, long-term liabilities have longer life span. Below are examples of accounts under each category of liability.
- Dividends payable
- Bank debts
- Rent, tax, wages and utilities payable
- Interests payable
- Current portion of long-term liability, and
- Customers prepayments.
- Long-term debt
- Deferred tax liability
- Pension fund liability.
It is important to know that there are some liabilities that are not recorded on the balance sheet, they are called 'off the balance sheet liability.'
Shareholders' equity refers to the amount of money that belongs to the owners of the company. Shareholders of a company are investors who hold a significant amount of the company's ownership. They are sometimes referred to as the owners of the company due to the number of shares owned. The forms of shareholders' equity are;
- Retained earnings: the earnings of the company set aside to pay dividends to shareholders, settle debts and for reinvestment purposes.
- Preferred stock or common stock which can be converted to common shares are a later date.
- Treasury stock, stock reserved to foil hostile takeovers.
- Contributed capital or additional paid-in capital.
Limitations of Balance Sheets
Despite that the balance sheet is of importance to analysts and those who want to invest in a company, it has some limitations. Below are some of the limitations of a balance sheet;
- A balance sheet is not a dynamic financial statement, it is static.
- The figures contained in a balance sheet can easily be influenced by factors such as inventories, depreciation or amortization.
- Financial managers can manipulate a company's balance sheet to make out attractive to investors.
- There are multiple accounting systems used for balance sheet.
Also, a balance sheet only contains the financial condition or position of a company for a specific time, and not historical periods.
Academic Research on Balance Sheet
- Thebalance sheetas an earnings management constraint, Barton, J., & Simko, P. J. (2002). The balance sheet as an earnings management constraint.The accounting review,77(s-1), 1-27. The balance sheet accumulates the effects of previous accounting choices, so the level of net assets partly reflects the extent of previous earnings management. We predict that managers' ability to optimistically bias earnings decreases with the extent to which the balance sheet overstates net assets relative to a neutral application of GAAP. To test this prediction, we examine the likelihood of reporting various earnings surprises for 3,649 firms during 19931999. Consistent with our prediction, we find that the likelihood of reporting larger positive or smaller negative earnings surprises decreases with our proxy for overstated net asset values.
- Commercial bank net interest margins, default risk, interest-rate risk, and off-balance sheetbanking, Angbazo, L. (1997). Commercial bank net interest margins, default risk, interest-rate risk, and off-balance sheet banking.Journal of Banking & Finance,21(1), 55-87. This paper tests the hypothesis that banks with more risky loans and higher interest-rate risk exposure would select loan and deposit rates to achieve higher net interest margins. Call Report data for different size classes of banks for 19891993 show that the net interest margins of commercial banks reflect both default and interest-rate risk premia. The net interest margins of money-center banks are affected by default risk, but not by interest rate risk, which is consistent with their greater concentration in short-term assets and off-balance sheet (OBS) hedging instruments. By contrast, (super-) regional banking firms are sensitive to interest-rate risk but not to default risk. The data show that OBS activities promote a more diversified, margins-generating asset base than deposit- or equity-financing, and that cross-sectional differences in interest-rate risk and liquidity risk are related to differences in OBS exposure.
- Balance sheeteffects, bailout guarantees and financial crises, Schneider, M., & Tornell, A. (2004). Balance sheet effects, bailout guarantees and financial crises.The Review of Economic Studies,71(3), 883-913. This paper provides a model of boom-bust episodes in middle-income countries. It is based on sectoral differences in corporate finance: the nontradables sector is special in that it faces a contract enforceability problem and enjoys bailout guarantees. As a result, currency mismatch and borrowing constraints arise endogenously in that sector. This sectoral asymmetry allows the model to replicate the main features of observed boom-bust episodes. In particular, episodes begin with a lending boom and a real appreciation, peak in a self-fulfilling crisis during which a real depreciation coincides with widespread bankruptcies, and end in a recession and credit crunch. The nontradables sector accounts for most of the volatility in output and credit.
- The central-bankbalance sheetas an instrument of monetarypolicy, Crdia, V., & Woodford, M. (2011). The central-bank balance sheet as an instrument of monetarypolicy.Journal of Monetary Economics,58(1), 54-79. We extend a standard New Keynesian model to allow an analysis of unconventional dimensions of policy alongside traditional interest-rate policy. We find that quantitative easing in the strict sense is likely to be ineffective, but that targeted asset purchases by a central bank can instead be effective when financial markets are sufficiently disrupted, and we discuss the conditions under which such interventions increase welfare. We also discuss optimal policy with regard to the payment of interest on reserves.
- A corporatebalance-sheetapproach to currency crises, Aghion, P., Bacchetta, P., & Banerjee, A. (2004). A corporate balance-sheet approach to currency crises.Journal of Economic theory,119(1), 6-30. This paper presents a general equilibrium currency crisis model of the third generation, in which the possibility of currency crises is driven by the interplay between private firms credit-constraints and nominal price rigidities. Despite our emphasis on microfoundations, the model remains sufficiently simple that the policy analysis can be conducted graphically. The analysis hinges on four main features (i) ex post deviations from purchasing power parity; (ii) credit constraints a la BernankeGertler; (iii) foreign currency borrowing by domestic firms; (iv) a competitive banking sector lending to firms and holding reserves and a monetary policy conducted either through open market operations or short-term lending facilities. We derive sufficient conditions for the existence of a sunspot equilibrium with currency crises. We show that an interest rate increase intended to support the currency in a crisis may not be effective, but that a relaxation of short-term lending facilities can make this policy effective by attenuating the rise in interest rates relevant to firms.