The balance sheet

A balance sheet reports the assets, liabilities, and equity of a business as of a specific point in time. The balance sheet is usually measured as of the end of a time period, which is why its title will state "as of [date]", rather than "for the period ended [date]".

The balance sheet can be used by itself to determine the amounts and relative proportions of the assets and liabilities of a business, which may lead to conclusions regarding the liquidity of the entity. When a series of balance sheets are reviewed in sequence, you can build trend lines that show changes in assets and liabilities, which can be used to estimate trends in liquidity. Or, if used in concert with a complete set of financial statements, a balance sheet can be used to obtain a complete picture of the financial results and financial position of a business.

The three key ingredients of a balance are:

  • Assets. This is an item that has economic value, and includes cash, accounts receivable, inventory, and fixed assets.
  • Liabilities. This is an obligation of the business, and includes accounts payable, wages payable, and debt.
  • Equity. This is the difference between assets and liabilities, and represents the cumulative earnings of the business from its inception, less any distributions to shareholders. If the reporting entity is a nonprofit, this section is instead called net assets.

The balance sheet may also incorporate several contra accounts, which are reserves used to reduce the balance in various asset and liability (and even equity) accounts. The most common contra accounts are the allowance for bad debts (used to reduce accounts receivable) and the reserve for obsolete inventory.

A balance sheet is usually presented as an aggregation of many general ledger accounts, with each line item including several similar accounts. For example, the cash line item includes the accounts for all of an entity's checking and savings accounts, while its inventory line item includes the accounts for raw materials, work-in-process, and finished goods. This type of aggregated reporting is known as a classified balance sheet.

Within the classified balance sheet, the largest aggregations of information are current assets, long-term assets, current liabilities, and long-term liabilities. The key indicator of whether an account should be classified as short-term or long-term is whether it will be settled (or resolved) within one year.

The accounting standards do not have a consistent methodology for assigning value to the line items in a balance sheet. The overriding principle is that any line item is recorded at its cost. However, you are supposed to record investments that are classified as available for sale at their market prices as of the balance sheet date, while you should use the lower of cost or market rule to reduce the recorded cost of inventory, and fixed assets can be reduced by an impairment charge (or revalued upward under IFRS). This inconsistent treatment of costs within the balance sheet means that the information it contains can be misleading.

Despite the costing problem just noted, the balance sheet can be used for a great deal of financial analysis of a business' performance, especially when combined with a review of its income statement, statement of cash flows, statement of changes in stockholders' equity, and accompanying financial disclosures. Some of the more common ratios that include balance sheet information are:

  • Accounts receivable collection period
  • Current ratio
  • Debt to equity ratio
  • Inventory turnover
  • Quick ratio
  • Return on net assets
  • Working capital turnover ratio

Many of these ratios are used by creditors and lenders to determine whether they should extend credit to a business, or perhaps withdraw existing credit.