Balance Sheet

What is a Balance Sheet?

A balance sheet presents a list of the assets, liabilities and equity at the end of the most current and previous reporting periods. It is built on the fundamental accounting equation (assets equal liabilities and equity) and provides the structural integrity for the financial statements. It presents a snapshot of a company’s financial position, unlike the income statement which is a record over a period of time.

The main objective of a balance sheet is to outline all the resources (assets) available to a business and how they are funded (liabilities). The liabilities and equity items provide the funds which are invested in assets. Many professionals refer to the balance sheet as a sources and uses statement.

How to Read a Balance Sheet

Source: Felix – The Coca-Cola Company – Balance Sheet

There are variations in the details of how balance sheets are presented, especially globally, but the fundamentals are the same. The assets are listed in order of liquidity; so, cash and cash equivalents appear at the top, while the last asset listed is intangible and other assets.

The most common presentation follows the accounting equation, with assets first, followed by liabilities and equity. This format is illustrated in the above statement. Some businesses rearrange the equation to show assets – liabilities = equity.

Historical Cost Basis

The statement provides a historical record of past transactions and their impact on assets, liabilities, and equity. This means that the amounts shown are unlikely to approximate market values. If the asset was purchased on the balance sheet date, then it may well be market value, but it might have been purchased many years earlier.

For many assets, decreases in their value are recorded, whereas increases are not. Inventory for example, is recorded at cost initially even though the resale value is expected to be higher than cost. However, if it is expected that the inventory will need to be sold at a loss, then the amount on the balance sheet will be written down to the expected recoverable amount.

Balance Sheet Components Explained

The statement comprises assets, liabilities, and equity. Many items fall into one of the three categories, and these are shown below:

Assets – Cash and Cash Equivalents

Cash and cash equivalents include cash and highly liquid assets with a short term to maturity (usually 90 days). This item is always categorized as a current asset.

Assets – Short-Term Investments

Short-term investments are marketable securities that can be converted to cash. A company with a surplus of cash may purchase these short-term financial assets.

Assets – Inventories

Inventories are a line item that represents the purchase price of goods held for resale. In a production-based business, the inventory is made up of raw materials, work in progress, and finished product. Inventory contributes to COGS (cost of goods sold) and is valued using either the First In First Out (FIFO) or Last In Last Out method.

Assets – Accounts Receivable

Accounts receivable are the amounts due from customers in respect of sales made to them on credit net of expected returns.

Assets – Property, Plant and Equipment (PP&E)

Property, plant and equipment are the tangible (physical substance) long-term assets expected to be used by the business for more than one year. They typically incur high costs to the business but produce benefits over several years. Subsequently, their cost is allocated to the income statement over time using a process called depreciation.

Liabilities – Accounts Payable

Accounts payable represent the amount due to suppliers for goods and services that have been delivered.

Liabilities – Income Taxes Payable

Income taxes payable are the taxes amount expensed in the prior period, modified for adjustment to the prior period’s estimates.

Liabilities – Debt

Debt is a line item that will represent a major source of funding for most businesses. It is a contractual liability and involves a commitment to repay the amount borrowed (principal) as well as all interest payments. The amounts must always be paid on the due date, regardless of circumstances.

Equity

Equity represents the ownership stake in the business. It provides a source of funding, but unlike liabilities, no repayment obligation exists. Equity is further divided into shareholders’ equity and retained earnings. It is the amount of money available to shareholders after all the company’s assets are liquidated and debts are paid off in the event of a liquidation.

Balance Sheet vs Income Statement vs Cash Flow Statement

The balance sheet presents the company’s financial position at a specific point in time. And for this reason, it can also be referred to as the statement of financial position. It’s a snapshot of all of the company’s assets, liabilities, and equity on a specific date. To put it simply, one half of the balance sheet shows everything the company owns. In other words, its assets, and the other half shows everything that it owes. In other words, its liabilities and its equity ultimately belong to the shareholders. These two sides must balance giving this statement its name.

The income statement shows the profit or loss made by the business over a certain period of time, which is why it is also sometimes called the profit and loss account or P&L account. It shows the revenue a business has made from sales, as well as any other income, such as interest on investments, and deducts from this. All of the costs a business has incurred, such as the cost of the goods they’ve sold, any marketing or admin expenses, as well as interest and tax expenses incurred. If total revenue is more than total costs, then the company has made a profit.

In this table, we compare the key features of the balance sheet, cash flow statement and the income statement:

Why Understanding the Balance Sheet Matters

The balance sheet is one of the core financial statements taught in accounting and finance. It introduces students to the accounting equation: Assets = Liabilities + Equity. Understanding it builds the groundwork for analyzing more complex financial concepts like leverage, liquidity, and valuation.

For Investors, a balance sheet reveals a company’s assets, liabilities, and equity, helping investors evaluate its liquidity, solvency, and capital structure. It supports decisions about whether a company is financially stable enough to invest in or lend to. Key ratios like debt-to-equity and current ratio are derived from balance sheet data.

Managers use the balance sheet to understand resource allocation, working capital, and funding needs. It helps guide strategic decisions such as expansion, cost control, or capital investment. Monitoring changes over time can highlight operational strengths or financial risks.

What a Healthy Balance Sheet Looks Like

A healthy balance sheet reflects a company’s strong financial position and stability. Here are the key characteristics of a healthy balance sheet:

Strong Asset Base – Sufficient current assets (cash, accounts receivable, inventory) to cover current liabilities, indicating good liquidity. Valuable long-term assets (property, plant, equipment) that support ongoing operations and future growth.

Low Debt Levels – Manageable short-term obligations that can be easily met with current assets. Reasonable levels of long-term debt, indicating that the company is not over-leveraged.

Positive Equity – Shareholders’ equity, strong equity position, showing that the company has retained earnings and capital contributions from shareholders.

Good Liquidity Ratios – A current ratio of current assets to current liabilities greater than 1, ideally between 1.5 and 2, indicating the company can meet its short-term obligations. A quick ratio of (current assets – inventory) to current liabilities greater than 1, showing the company can meet short-term liabilities without relying on inventory sales.

Healthy Solvency Ratios – A low debt-to-equity ratio, typically less than 1, indicates that the company is not excessively reliant on debt financing. A high interest coverage ratio, indicates that the company can comfortably cover its interest expenses with its earnings before interest and taxes (EBIT).

Positive Working Capital – Positive working capital (current assets minus current liabilities), indicating that the company has sufficient short-term assets to cover its short-term liabilities.

Consistent Profitability – Retained earnings, accumulated profits that have been reinvested in the business, showing a history of profitability and growth.

Example of a Healthy Balance Sheet

A balance sheet with these characteristics indicates that the company is financially healthy, with a strong asset base, manageable debt levels, and sufficient liquidity to meet its obligations.

Conclusion

Understanding a balance sheet is crucial for anyone involved in financial analysis, investment, or business management. It provides a snapshot of a company’s financial position at a specific point in time, detailing its assets, liabilities, and equity. This information is essential for assessing a company’s liquidity, solvency, and overall financial health. By mastering the components and interpretation of a balance sheet, you can make more informed decisions, whether you’re evaluating a potential investment, managing a business, or simply seeking to enhance your financial literacy. Remember, the balance sheet is just one piece of the financial puzzle, but it’s a foundational one that offers valuable insights into a company’s stability and performance.