Balance Sheet

Structure of a balance sheet

Figure 1 shows the overall structure of a company's balance sheet with assets, liabilities, and equity.

Table 1 - Balance Sheet Structure

Balance Sheet: Assets

Assets are anything that a business owns. They can be classified into fixed assets and current assets.

Fixed assets (or non-current assets) are a company’s possessions that will not be sold in the near future. They tend to last for a long time and are used to produce goods or services. Fixed assets are not easily converted into cash.

Current assets are a company’s possessions used in production or to pay for raw materials. Unlike fixed assets, they are only held for a short period of time. Current assets are easily converted into cash.

Balance Sheet: Liabilities

Liabilities are what a company owes to creditors or the bank. They can be divided into current liabilities and long-term liabilities.

Current liabilities are what a business owes in the short run. These are debts that will be paid back within a year.

To calculate net current assets:

$\mathrm{Net}\mathrm{Current}\mathrm{Asssets}=\mathrm{Current}\mathrm{Assets}-\mathrm{Current}\mathrm{Liabilities}$

Long-term liabilities are what a business owes in the long run. These are debts that will be paid back over many years, for example, bank loans or mortgages (loans to purchase property).

To calculate the overall wealth of a business:

$\mathrm{Net}\mathrm{Assets}=\mathrm{Total}\mathrm{Assets}-\mathrm{Total}\mathrm{Liabilities}$

Balance Sheet: Total equity

Total equity is a business's capital that belongs to shareholders. This is the money remaining if the business uses up all its assets. In this case, total equity is used to pay for the company's debts.

The total equity can come from:

• Share capital: the original amount invested by shareholders.

• Reserves: funds set aside to pay future obligations.

• Retained earnings: company profits that are not distributed to shareholders.

Equation of a balance sheet

‘Balance’ means that two things should be equal. The balance sheet is so-named because each part of the document is equal to the other.

'Net assets employed' refers to the value of assets belonging to the business. This is the exact amount of money invested in the business by the shareholders, known as total equity or capital employed.

Thus, the equation of the balance sheet:

$\mathrm{Net}\mathrm{Assets}=\mathrm{Total}\mathrm{Equity}$

Since Net assets = Assets - Liabilities, we also have:

$\mathrm{Assets}=\mathrm{Liabilities}+\mathrm{Total}\mathrm{Equity}$

How do you interpret a balance sheet?

The balance sheet is one of the documents that a business's stakeholders, such as managers, suppliers, and owners, will be most interested in. An investor also may want to read and analyse a company's balance sheet before investing in its stock.

The balance sheet shows how the value of a company has changed by comparing the 'net assets employed' of the current year with the previous years. An increase in assets is generally a good sign, as it indicates growth. However, you need to look more into a balance sheet's structure to see what really happens behind the scenes.

A balance sheet is divided into two main sessions: Assets and Liabilities and Equity. In all balance sheets, the value of assets is always equal to the combined value of Liabilities and Equity.

Another way to analyse a balance sheet is to use ratios such as financial strength ratios and activity ratios. Financial strength ratios include working capital and debt-to-equity ratios, which show how financially stable a company is and how it finances itself. Activity ratios indicate the efficiency of a company's operations. These include inventory turnover, accounts receivable, and payables.

Balance sheet example

Now that we’ve learned different components of the balance sheet and how to interpret it, let’s consider an example:

C Corporation sells sustainable activewear products. Figure 2 shows the business’s balance sheet for 31 December 2021.

As you can see in Figure 2, the total assets of C Corporation equal its total liabilities and equity, around £410 million. The balance sheets also reveal the value of assets, shareholders' equity, and how much a company owes to others (liabilities). A further look into C Corporation's assets and liabilities shows its current assets, fixed assets, and the money it has to pay in the short and long run.

Along with the income statement and cash flow statement, the balance sheet is one of the most important tools for stakeholders to assess a company's value and growth potential. It provides a snapshot of a company's financial position through its assets, liabilities, and equity. Let's wrap up this explanation with a few key takeaways.