What is a Balance Sheet and is it Important?
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Essentially a balance sheet provides an overview of a company's assets, liabilities, and shareholder equity for the accounting period. So what you will find when reviewing a balance sheet is everything the business owns, what it owes, and how much the investors have into the business. This in turn allows you to better understand what the company's financial position is, based upon the period that the balance sheet covers. In this article, we will look more closely at what a balance sheet entails and the various parts that constitute the balance sheet as a whole.
The Items on a Balance Sheet
As noted, a balance sheet will show all assets, liabilities, and shareholder equity in the company. Broken down, these represent the following:
Assets will be all that the company has that possesses cash value. In reporting these assets, you want to be sure and list them in order of liquidity. So in other words, how quickly/easily can an asset be converted into cash. Among the items that you will include on your balance sheet under the assets category:
Current Assets: This represents those assets that take the least amount of time to convert to cash (usually less than a year/). Under current assets, you will find things such as cash, cash equivalents, securities, and investments that can be sold within a year, accounts receivable, inventory if you sell products (both finished product and raw material/), and any prepaid items such as rent for example.
Long-Term Assets: These are not such that can be converted to cash within a year. Long term company assets will include long term securities, real estate, machinery, buildings, office equipment such as electronics, and then those intangible assets like copyrights and patents.
Liabilities represent the amount of money that a firm owes to others. This could include for example recurring expenses such as loan repayments and/or other such debt. As with assets, your liabilities are broken down into categories:
Current liabilities: These will include that which you immediately and regularly pay, so for instance rent, utilities, taxes, loan repayments, and payroll among other liabilities.
Long-term liabilities: In this category, you will likely find things such as pension fund liabilities as well as long terms loans.
Shareholder's equity signifies the money the business makes, the amount invested into it by the owners or shareholders, and any other capital given to the business. This represents a company's net assets and is calculated by subtracting the total amount of liabilities from the total amount of assets.
The Point of a Balance Sheet
As the name suggests, the balance sheet ultimately needs to balance out. So when creating this sheet, if in fact, it fails to balance in the end, then you need to revisit the numbers. It will be divided into two sections. On one side you will have your assets and on the other will be the liabilities and shareholder equity. In the end, the total assets have to be equal to the liabilities and shareholder equity combined and in this way, the balance sheet balances. The most basic formula associated with a balance sheet is Assets = Liabilities + Shareholder equity.
Why Do You Need a Balance Sheet?
The balance sheet does offer a fairly good overview of the financial well-being of a company. And in looking at the balance sheet in tandem with other relevant financial statements, you can compare accounts and thereby gain some valuable insights. For instance, you can get a better understanding of how liquid the company is at a given period. In reviewing assets against liabilities, you stand to see how much cash the company does have on hand. Knowing how liquid you are is key, as should something arise in the short term, you want to be sure you can cover the expenses.
Also, if you look at your balance sheet in conjunction with your income statement you come to see how effectively the business is managing its assets. Are you using your assets to generate revenue efficiently?
Main Financial Statements
The balance sheet can paint a picture of where your company stands financially speaking. It is one of four main financial statements that when taken together can give you a more comprehensive view of the financial status of the business. Beyond the balance sheet which as we have seen lists all assets, liabilities, and shareholder equity, there is also the income statement. An income statement (sometimes referred to as a profit and loss statement/) shows the company's revenue, expenses, and profits and/or losses for a reporting period. Most consider the income statement to be the primary financial statement. There is also a cash flow statement. A cash flow statement allows you to see what is coming in versus the amount of cash going out of the business during a specified period. Many lenders want to see this as it presents a pretty good idea of whether or not a company has enough money coming in to cover loan repayment. There is also the statement of retained earnings. This essentially shows any equity changes during the accounting period and can include things such as the sale of stock, dividend payments, and so forth.
Why should you generate these statements and in particular a balance sheet? For one, understanding what assets you have versus your liabilities can help you make more informed decisions for the business moving forward. Not to mention, when looking at all of your financial statements and piecing together an overall picture, you can begin to see where your biggest ROIs are and consequently, in what areas some adjustments may have to be made so that you don't suffer down the road.
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