What is a Balance Sheet?
What is a business worth? To get the answer, you’ll need to look at its balance sheet. A balance sheet is a statement showing an entity’s financial position by reporting on assets, liabilities and shareholders’ equity on a specific date (commonly at the end of an accounting period). It shows what a company owns and owes, as well as shareholders’ ownership.
A balance sheet is one of the core financial statements every public company needs to issue regularly. It’s something every investor should get familiar with and understand, because it provides significant context for the financial health and worth of a business. Here’s everything you need to know about a balance sheet.
What’s Recorded on a Balance Sheet?
Balance sheets for public companies have three definitive sections: assets, liabilities and equity. The “balance” comes from looking at what’s owned vs. owed:
Assets = Liabilities + Shareholder Equity
- Assets are what the company owns, and include both current and fixed assets.
- Liabilities are debts owed by the company, including loans.
- Equity represents the amount of business equity offered by shareholders.
Within each of these sections is a more comprehensive breakdown that accounts for the sum total of each column on the balance sheet. For example, under assets you’d find cash and cash equivalents, accounts receivable, inventory, fixed assets, intangible assets and more. Likewise, under liabilities you might find loans, accounts payable, deferred tax liability and more. Finally, the equity section would include line items for reinvested earnings and common stock.
Balance sheets need well-organized attribution to ensure readers can identify the major contributors to each section. Specific line items for each type of asset, liability and equity bring clarity to the report as a whole.
How Does it Work?
The balance sheet tells the story of how a company operates: it acquires assets by borrowing money or issuing equity. While a company’s balance sheet is much more nuanced, the fundamental activity remains the same.
The balance sheet needs to live up to its name by staying in balance. To do this, companies rely on double entry accounting practices. Every entry on the balance sheet needs an offsetting entry somewhere else. Some examples include:
- When a company gets a loan, both liabilities and cash assets increase by the loan amount.
- As the company pays back that loan, it reduces cash assets and liabilities similarly.
- The company buys a machine, which reduces cash assets but adds a new fixed asset.
- The company issues shares, which increases equity and cash assets in tandem.
So long as the balance sheet remains in balance, the financial picture of the company makes sense. A balance sheet that’s overweight to one side or the other indicates an accounting issue that requires auditing to remedy. The balance sheet needs to live up to its moniker.
What is it Used For?
Balance sheets are a great window into a company’s general financial health. Executives and investors alike can see, at a glance, what the company owns and owes, and a generalized breakdown of these figures. Ultimately, the balance sheet shows the net worth of a company.
A balance sheet can also indicate the near-term financial capabilities of a business. For example, does it have enough cash on hand to pay its coming debts? Is it paying an appropriate dividend based on the balance sheet—or is it in danger? What is the debt-to-equity ratio of the company? These questions all provide context for investors as they evaluate the prospects of investing in a company.
What Can’t a Balance Sheet Tell You?
While balance sheets provide a great snapshot of the company’s financial health, they’re not indicative of trends. There’s no perspective on cash flow, for example. An otherwise healthy-looking balance sheet might mask the fact that the company has irregular cash flows and problems managing accounts receivable and accounts payable.
Balance sheets are also relatively easy to manipulate through creative (yet legal) accounting practices. For example, some companies will depreciate inventory to improve the balance sheet without actually posting improved sales figures.
The balance sheet is best reviewed in tandem with income and cash flow statements. These other financial reports provide important context for the assets, liabilities and equity recorded on the balance sheet.
Where to Find a Company’s Balance Sheet
The Securities and Exchange Commission (SEC) requires public companies to file balance sheet statements regularly. Investors can find this information in the company’s 10-K and 10-Q filings. These filings will also include other financial documentation, such as income statements.
Using balance sheet information from a company’s 10-K or 10-Q comes with assurance of financial accuracy. A third-party external auditor verifies them to be accurate and true. That means you can expect GAAP compliance and independently certified financial data. Investors can generally take these numbers at face value, pending an unqualified (or qualified) audit opinion.
Get Familiar With the Balance Sheet
Balance sheets are one of the fundamental financial reports every investor needs to get familiar with. Thankfully, they’re easy to read and understand with a little practice. And moreover, you can use these reports to determine if the company is a good investment for you. For more stock tips, sign up for the Trade of the Day e-letter below. This daily newsletter provides stock tips, trends and picks from Wall Street experts with decades of experience.
Getting comfortable with a balance sheet means being able to draw conclusions about the financial health of a company and its future wealth prospects. This, in turn, helps investors identify investment opportunities and avoid pitfalls. Consult a company’s balance sheet as often as it issues one to identify changes that show positive trends in net worth—or negative trends concerning debts and equity.