Project Management steps & tools
University of Malta
Institute for Tourism, Travel & Culture
A balance sheet is a financial statement that reports a company’s assets, liabilities and shareholders’ equity at a specific point in time. It provides a good basis for calculating rates of return and evaluating its capital structure.
Most of all it is a financial statement: it gives us a snapshot of what a company owns and owes, as well as the amount invested by shareholders.
The balance sheet is used alongside other important financial statements. As noted earlier, these include the
statement of cash flows.
Together they provide the tools with which to analyse or calculate financial ratios.
Balance Sheet formula
Assets = Liabilities + Shareholders’ Equity
This formula is intuitive: a company has to pay for all the things it owns, namely its assets, by either borrowing money (i.e. taking on liabilities) or taking it from investors (i.e. issuing shareholders’ equity).
For example, if a company takes out a five-year, €4,000 loan from a bank, its assets (particularly, the cash account) will increase by €4,000. Its liabilities (particularly, the long-term debt account) will also increase by €4,000, thereby balancing the two sides of the equation. If the company takes €8,000 from investors, its assets will increase by that amount, as will its shareholders’ equity. All the revenues the firm generates over and above its expenses will go into the shareholders’ equity account. These revenues will be balanced out on the assets side, appearing as cash, investments, inventory, or some other asset.
Components of Balance Sheets
Assets, liabilities and shareholders’ equity each consist of several smaller accounts that break down the specifics of a firm’s finances.
These accounts vary widely by industry and by sector, and the same terms can have different implications depending on the nature of the business.
However, generally speaking, there are a few common components investors are most likely to come across.
The context of balance sheets
The balance sheet is a snapshot representing the state of a company’s finances at a moment in time. By itself, it cannot give a sense of the trends that are playing out over a longer period.
For this reason, the balance sheet should be compared with those of previous periods.
It should also be compared with those of other businesses in the same industry since different industries have unique approaches to financing.
A number of ratios can be derived from the balance sheet, assisting investors to manage get a sense of the state of health of a company.
These include the debt-to-equity ratio and the acid-test ratio, along with many others.
The income statement and statement of cash flows also provide important context for assessing a company’s finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet.
Limitations of Balance Sheet
The balance sheet is an important piece of information for investors and analysts.
However, it does have limitations. Since it is just a snapshot in time, it can only use the difference between this point in time and another single point in time in the past.
Because it is static, many financial ratios draw on data included in both the balance sheet and the more dynamic income statement and statement of cash flows, in order to paint a fuller picture of what is the state of a company’s business.
Different accounting systems and ways of dealing with depreciation and inventories will also change the figures posted to a balance sheet. Therefore, managers may have enough room to present numbers more favourably. Pay attention to the balance sheet’s footnotes in order to determine which systems are being used in their accounting and to look out for red flags.