Balance Sheet B/S (Statement of Financial Position) Explained
Structure, Meaning, and Examples
Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2014-07-25.
On the balance sheet Assets always equal the sum of Liabilities plus Owners Equities. Financial position is shown by comparing balance sheet categories with each other (as with Working Capital), or with income statement categories (as with Return on Assets)
The balance sheet (B/S, or statement of financial position) is one of the four primary financial reports (financial accounting statements) that publicly held companies must file every quarter and year. The other three are the income statement, the statement of retained earnings, and the cash flow statement (or statement of changes in financial position, or financial cash flow statement). Balance sheets for government and non profit organizations are also published periodically, often called "Statement of Financial Position."
For a specific point in time, the B/S reports:
• What an entity owns outright (equities).
• What the entity owes (liabilities).
• The resources the entity has to work with (assets).
More accurately, the balance sheet reports the end of period balances in the entity's asset, liability, and equity accounts. The balance sheet is normally prepared and published as one of the final closing events for an accounting period, after all the period's transactions are posted to general ledger accounts, after a trial balance period in which accountants search for and correct transaction and posting errors.
In principle, a company or organization could publish a new and different version of the balance sheet every day, but they normally do so at the end of fiscal quarters and years. The B/S heading identifies the time point with a phrase such as this: "...at 31 December 2013." The B/S is thus a "snapshot" of the etntity's financial position at one time point, whereas the income statement and statement of changes summarize financial activitiy for a specific period of time (quarter or year).
The balance sheet’s 3 main sections represent the so-called accounting equation:
Assets = Liabilities + Owners equity
The term balance means that the sum of the entity's assets must equal (balance) the sum of its liabilities and owner’s equities. This balance holds, always, regardless of whether the company's financial position is good, or terrible. Principles of double entry bookkeeping and accounting ensure that every transaction that impacts the total on one "side" of the B/S brings an equal, offsetting change in the total for the other "side."
Analysts evaluate the "health" of the company's financial position not by the overall magnitude of the Assets number, or its balancing counterparts, but rather by the relationships between numbers on the sheet. (See the section on B/S contributions to financial statement metrics and ratios, below.)
Balance sheet: Simple example and main categories
This sheet example shows the major categories usually reported under assets, liabilities, and equities.
The entire sheet is sometimes presented in horizontal layout, with an Assets Page on the left, and a page for Liabilities and Equities on the Right. Alternatively, it can be presented in vertical format (as above), with the Assets Section above the Liabilities and Equities sections that, together, balance it.
The main categories shown above are defined after the more detailed example below.
Keeping the balance: debits and credits
Many people readily understand the structure and mathematics of the income statement, but have trouble understanding the balance sheet. One reason for this, probably, is that the income statement simply starts with revenues, and then subtracts expense items to reach a bottom line net profit., in much the same way that individuals manage a personal checkbook register. Understanding B/S dynamics requires, however, understanding a few basic principles of double entry bookkeeping and accounting.
Those familiar with accounting systems may also note that most of the balance sheet line items are really the names of accounts from the organization's Chart of Accounts, specifically, the "Assets," "Liability," and "Equity" category accounts. (For more on building the balance from accounts and account balances, see the encyclopedia entry Trial balance.)
Both the income statement and the balance sheet start with simple equations. For the income statement, this is:
Income = All Revenues – All expenses and costs
The balance sheet starts with an equally simple equation, the accounting Equation:
Assets = Liabilities + Owners Equity
Regarding the balance sheet and double entry bookkeeping, it is sometimes said that the Accounting Equation above must be extended to include this component:
Debits = Credits
In normal usage, people think of debits to, for example, their checking accounts, simply as subtractions, and credits to the checking account simply as additions. Banks in fact use this terminology on statements to account holders. To accountants, the bank's usage is technically correct, but this is only because the bank regards an account holder's account as a liability account for the bank. In double entry bookkeeping, for accounts on the "Liabilities and Equities" side of the sheet:
- Increasing the value of a liability, equity, or so-called revenue account is a credit.
- Decreasing the value of a liability, equity, or revenue account is a debit.
On the other side of the balance sheet—the "Assets" side—the rules for debits and credits are reversed:
- Increasing the value of an asset or an expense account is called a debit.
- Decreasing the value of an asset or an expense account is called a credit.
In double entry bookkeeping and accounting, every transaction must impact at least two accounts. Whether the impact is called a "debit" or a "credit," depends on the kind of account involved, as described above.
Suppose the company acquires assets valued at $1,000. An asset account (perhaps under Current Assets) increases $1,000—considered a debit transaction because the account is on the asset side of the sheet. The sheet is now temporarily out of balance, until a second transaction is made, a credit transaction of the same size. This could be either
- A corresponding reduction in another account on the Asset side of the sheet, e.g., a credit (i.e. reduction ) to a cash account also under Current assets, or a credit to an Expense account (which will be transferred to the Asset side of the sheet)
- A corresponding increase in an account on the Liabilities and Equities side. For example, an increase (credit) of $1,000 to a long term liabilities account if the purchase funds were borrowed.
In this way, balance sheet assets will always equal liabilities plus equities and debits will always equal credits.
Detailed report example
A more detailed version of the example statement from above is presented here. Definitions for the major categories and line items appear below the example.
On the Assets side, the major categories usually include:
Current assets: These are assets that, in principle, could be turned into cash in a relatively short time. "Short time" is generally understood to be one year or less. Current assets includes, of course Cash on hand, but also Short term investments, Accounts receivable, Inventories, and Prepaid expenses.
Long term investments and funds: These are assets that are not so easily turned into cash quickly, which include ownership of stocks and bonds in other companies, as well as other long term (over one year) investments.
Property, plant & equipment: These are the company's major physical assets, including such things as buildings, factory machines, vehicles, and large computer systems. The cost of these assets is normally charged against income as depreciation expense across the depreciable life of the asset. Note that each year of the asset's depreciable life, the depreciation expense contributes to accumulated depreciation, reducing the "book value" of the TOTAL assetS.
Intangible assets: Assets which cannot be seen or touched, but which arguably are (a) owned by the company, which has exclusive rights to them, and (b) contribute to earning ability. These may include copyrights and patents, trademarks, brand image, and goodwill.
On the Liabilities and Equities side, the major categories usually include:
Current liabilities: These are generally described as the obligations the company has that must be met within a short time, such as one year or less. They may include such things as accounts payable, the current portion of long term debt that is due, and estimated short term warranty obligations.
Long term liabilities: These are obligations that are not due immediately, but due instead for a period longer than one year. Long term liabilities may include bank notes payable, bonds payable, or long term financing arrangements for purchases.
Contributed capital: One of the two main categories under Owner’s equity (the other is Retained earnings). Contributed capital shows what has been invested by stockholder’s through purchase of stock from the corporation (not through purchase of stock on the open market from other stockholders). Contributed capital, in turn, has two main components: Stated capital, which represents the stated, or par value of the shares, and Additional paid-in capital, which represents money paid to the company above the par value.
Retained earnings: The part of a company’s income kept to accumulate, after dividends are paid. The company’s accumulated retained earnings appear on the Balance Sheet under Owner’s Equity .After a profitable period, a company can (at the discretion of its board of directors) pay some of its income to shareholders, as dividends, and keep the remainder as retained earnings.
B/S contributions to financial statement metrics and ratios
The balance sheet is a primary source for input into financial metrics and financial statement ratios that address questions like these:
What are the company's prospects for future earnings?
Valuatio metrics such as the price to earnings ration deal with such questions.
Is the company prepared to meet its short term financial obligations?
Liquidity metrics such as current ratio address questions of that kind.
Is the company using its resources efficiently?
Activity metrics such as inventory turns are designed for such questions.
Are the company's funds supplied primarily by owners or by creditors?
Leverage metrics, such as debt to asset ratio provide answers
Is the company profitable? Is it making good use of its assets?
Profitability metrics such as operating margin address such questions.
How does the company's growth over the last five years compare to similar companies? To industry averages? Growth metrics such as the cumulative average growth rate CAGR for Sales revenues address such questions.
Financial statement metrics are generally used by…
- Investors considering buying or selling stock or bonds in a company.
- Company management, for identifying strengths, weaknesses, and target levels for business objectives.
- Shareholders and boards of directors, for evaluating senior management.
For a complete introduction to these financial statement metrics, along with working spreadsheet examples and templates, see Financial Metrics ProTM.
By Marty Schmidt. Copyright © 2004-.