What is a Balance Sheet?
A balance sheet is one of the four financial statements produced by a company every quarter and year. In contrast to the income statement, retained earnings statement, and cash flow statement, which cover a time period (quarter or year), the balance sheet is a snapshot in time.
It lists all assets, liabilities and equity for the reporting date and contains numbers that can give us crucial insights into whether a company is a good investment or not.
Structure of a Balance Sheet
A balance sheet contains three major categories that give an overview of a company’s finances:
- Assets: what the company owns
- Liabilities: what the company owes
- Shareholders’ equity: the amount of money left over for shareholders after liquidation of the company and after all debt has been paid off.
Assets are listed on the left, and liabilities and total shareholders’ equity on the right.
The balance sheet gets its name from the fact that its left and right sides balance each other. This is expressed in the accounting equation, which states that assets are always the sum of liabilities and shareholders’ equity:
Assets = Liabilities + Shareholders’ Equity
The sub-categories explained below are the same for most companies. However, accounting allows some flexibility in what to call certain categories, also called accounts. So don’t be surprised to see different sub-category names for different companies’ financial statements.
The asset section is split into current assets (top) and non-current assets (bottom). These combined make up the total assets.
Current assets are either cash or can be converted to cash quickly, within 1 year. Non-current assets are long term assets.
Cash & Short-Term Investments
Cash is the cash currently in the bank, whereas short-term investments include assets like short-term certificates of deposit (CDs), short-term treasury bonds, and assets that can be converted to cash quickly. These are also called liquid assets.
Total inventory sums up the production value of a company’s inventory. This is a useful number for investors as it allows us to track inventory levels. Are inventory levels piling up? This can be a red flag.
Total Receivables, Net
Total receivables summarizes any outstanding payments to the company for products and services that were purchased by customers on credit. It can be an indicator about how efficient a company is at collecting payments, which is beneficial for cash flow.
Prepaid expenses summarizes any expenses for goods and services the company paid in advance, without receiving the goods or services yet. An example is unexpired insurance premiums.
Other Current Assets
Other current assets are non-cash items that are due within a year, but not yet on the company’s accounts as cash; for instance, deferred income tax recoveries.
Total Current Assets
Here, all current assets are summed up. Total current assets is used to calculate the current ratio, a traditional measure of financial stability.
Property, Plant, Equipment
As the name suggests, this account lists the value of a company’s property, manufacturing plants and equipment. The value is the initial cost, minus any depreciation.
Goodwill is an intangible asset that gets recorded when a company acquires another company for a price higher than the acquired company’s book value of equity. The difference between the price paid, and the book value, is goodwill.
Other Intangibles, Net
This account lists the value of any intangible assets that were acquired through acquisition of other companies. This includes brand recognition, franchises, or intellectual property, such as patents, copyrights and trademarks. Any patents developed in-house through research & development cannot be stated on the balance sheet and therefore are not listed here. The costs for their development, instead, are recorded as an expense on the income statement.
Long-term investments is an asset account for any investments that a company intends to hold for more than one year, including stocks, bonds, real estate, and a company’s affiliates and subsidiaries.
Other assets are any assets with useful lives above one year that didn’t fit in any other non-current asset accounts.
Total assets is the sum of all asset accounts and can be used to calculate the return on assets ratio.
Similar to a balance sheet’s asset section, the liabilities are split into current (top) and non-current (bottom). Current liabilities are any payments due within the current fiscal year. Non-current liabilities have a time horizon longer than one year.
Accounts payable is money owed to suppliers for goods and services that the company paid for on credit. For example, when a pharmaceutical company orders lab supplies and gets the invoice to pay within 30 days, the amount due is recorded under Accounts Payable.
Accrued expenses are liabilities such as accrued rent payable and sales tax payable. These are expenses the company incurred, but hasn’t been asked to pay yet.
Short-term debt is a liability owed by the company and due within the fiscal year. Examples include commercial paper (a type of unsecured debt issued by companies), or short-term bank loans. Short-term debt is a useful metric when compared to long-term debt. The ratio can indicate how risky a business is.
Long-Term Debt Due
Long-term debt due is the proportion of long-term debt that needs to be paid back within the current fiscal year. While most businesses don’t have an obligation to pay long-term debt back on a yearly basis, some companies do.
Other Current Liabilities
Other current liabilities is a summary account for any short-term liabilities that don’t fit in any of the other current liabilities accounts.
Total Current Liabilities
Total current liabilities is the sum of all current liabilities and is a useful number to calculate the current ratio, a measure of financial stability.
Long-term debt is any money owed further out than the current fiscal year. Little or no long-term debt compared to earnings is a good sign of financial stability.
Deferred Income Tax
Deferred income tax is tax owed that hasn’t been paid yet.
To understand minority interest, let’s assume that Company A owns the majority of Company B’s stock. Let’s say 90%. Because it owns more than 50% and has a controlling interest, Company A is allowed to transfer Company B’s entire assets and liabilities onto its own balance sheet. To reflect that Company A owns only 90%, the value of the minority interest that remains (100 – 90% = 10%) with Company B is recorded as the minority interest on Company A’s balance sheet.
Other liabilities are any non-current liabilities that don’t fit in the other categories. Some examples include unpaid fines or interest on taxes due.
Total liabilities is the sum of all liability accounts. It is used to calculate the ratio of debt to shareholders’ equity, which helps investors figure out whether a company finances its operations with debt, and to what extent.
The shareholders’ equity portion of the balance sheet shows how much the owners of the company have invested in it. This can either be in the form of preferred or common stock, or as retained earnings which accumulate over time. In addition, this section also contains accounts such as additional paid in capital, and treasury stock.
Let’s have a look at each of these in more detail below.
Shareholders of preferred stock have the right to a fixed or adjustable dividend, whereas common stock shareholders don’t necessarily receive a dividend. However, preferred stock shareholders don’t have the right to elect the board of directors, whereas common stock shareholders do.
Most companies don’t issue preferred stock when raising new capital, and instead choose to only offer common stock. The reason is this: in contrast to interest paid on loans, which is deductible from pretax income, the dividends paid on preferred stock (and common stock, should there be a dividend) are not, therefore making preferred stock an expensive option to raise capital.
Thus, many balance sheets don’t list any value for preferred stock, because they didn’t issue any.
Common stock refers to all common shares that were given out to the public when the company raised capital. The value recorded on the balance sheet is the par value of the shares.
A par value is simply the original value of the share as stated in a company’s charter, but it doesn’t reflect the actual value of the shares. For example, Thermo Fisher carries each common share at a par value of $1 (this information is listed in the annual reports), even though the value of each share is much higher.
Retained earnings are any net earnings left over after paying dividends and buying back shares. Thus, companies that have positive net earnings, don’t pay out dividends, and don’t buy back shares, retain 100% of their earnings, and these get added to the pool of retained earnings every reporting period.
These retained earnings can then be used in the future when value-creating investment opportunities present themselves, for instance for projects or to acquire other companies.
If a company reports a net loss one year, this amount gets subtracted from the retained earnings.
Retained earnings is a crucial number for investors. If retained earnings shrink over time, or the company doesn’t increase its retained earnings through additions, the company is not growing its net worth. If the net worth doesn’t grow long-term, what do you think the share price will do long-term?
When a company repurchases its own preferred or common stock, the value is recorded on the treasury stock account.
In general, share buybacks are beneficial for shareholders as the company value is distributed over less shares after the stock repurchase.
Total Shareholders’ Equity
The total shareholders’ equity is the sum of the preferred and common stock accounts, additional paid in capital, retained earnings, other equity, minus the treasury stock.
Total shareholders’ equity is also called the net worth, book value, or equity book value of the company. This is because it is the result of subtracting the total liabilities from the company’s total assets. Similar to your own personal net worth, which is your personal liabilities subtracted from your personal assets.
For investors, total shareholders’ equity is extremely valuable because it is the denominator of return on equity (ROE), a critical number to assess how efficient a company is at allocating capital.