Balance Sheet

A Balance Sheet is a financial statement that provides a snapshot of a company’s financial position at a particular point in time. It shows what the company owns (assets), what it owes (liabilities), and the equity of the owners. The balance sheet follows the accounting equation.

• $$\text{Assets}=\text{Liabilities}+\text{Equity}$$

Assets

Assets are economic resources owned by a company that are expected to provide future benefits. They are categorized into current and non-current assets.

Current Assets (Expected to be converted into cash or used within one year)

• Cash and Cash Equivalents: The most liquid assets, including physical cash, bank accounts, and short-term investments (e.g., Treasury bills).
• Accounts Receivable (AR): Money owed to the company by customers for goods or services provided on credit. The company expects to collect this within a specified period, typically within 30-90 days.
• Inventory: Goods or products that are held for sale or production. Inventory is broken down into:
  • Raw Materials: Basic components used to manufacture products.
  • Work-in-Progress (WIP): Partially completed products.
  • Finished Goods: Products ready for sale.
• Prepaid Expenses: Payments made in advance for goods or services to be received in the future, such as insurance premiums or rent.

Non-Current Assets (Expected to be held or used for more than one year)

• Property, Plant, and Equipment (PP&E): Physical, tangible assets that are used in operations, such as buildings, land, machinery, vehicles, and furniture. These assets are subject to depreciation, which spreads their cost over their useful life.
• Intangible Assets: Non-physical assets with value, like patents, copyrights, trademarks, and goodwill. Intangible assets are often amortized over their useful lives.
• Investments: Long-term investments that a company plans to hold for over a year, including bonds, stocks, or joint ventures.

Liabilities

Liabilities are financial obligations or debts that a company must settle in the future. They are divided into current and non-current liabilities.

Current Liabilities (Due within one year)

• Accounts Payable (AP): Amounts the company owes to suppliers for goods or services purchased on credit.
• Short-Term Debt: Loans or other borrowings that must be repaid within one year, including the current portion of long-term debt.
• Accrued Expenses: Expenses that have been incurred but not yet paid, such as wages payable, interest payable, and utilities.
• Deferred Revenue: Payments received by the company for goods or services not yet delivered. This represents a liability until the service or product is provided.
• Taxes Payable: Income taxes owed to the government but not yet paid.

Non-Current Liabilities (Due after one year)

• Long-Term Debt: Loans or bonds that are payable after more than one year. This could include bank loans or issued bonds.
• Deferred Tax Liabilities: Taxes that are due in the future but arise due to timing differences between accounting practices and tax rules. For instance, a company might delay recognizing certain expenses for tax purposes.
• Pension Liabilities: The company’s obligation to pay its employees’ pensions in the future.

Equity

Equity represents the residual interest in the assets of the company after deducting liabilities. It is the owners’ claim on the company’s resources. Components of equity include:

• Share Capital: The amount of money invested by shareholders in exchange for ownership (shares). This could be further divided into:
  • Common Stock: Equity ownership with voting rights and a residual claim on the company’s assets.
  • Preferred Stock: Equity ownership with priority on dividends but usually without voting rights.
• Retained Earnings: The accumulated net income that has been reinvested in the business rather than paid out as dividends.
• Treasury Stock: Shares that were previously issued and outstanding but have been repurchased by the company. These shares are deducted from equity since they are no longer considered active ownership.
• Other Reserves: Includes revaluation reserves, foreign currency translation adjustments, and unrealized gains or losses on securities held.

Key Ratios and Metrics

Balance Sheet ratios are used by investors, analysts, and management to evaluate the financial health of a company:

Liquidity Ratios (Measure the company’s ability to meet short-term obligations)

1. Current Ratio: Measures the company’s ability to pay short-term liabilities with short-term assets.

   Current Ratio=Current AssetsCurrent Liabilities\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}Current Ratio=Current LiabilitiesCurrent Assets

   • A ratio above 1 means the company has more current assets than current liabilities, indicating good liquidity.

2. Quick Ratio (Acid-Test Ratio): Measures the ability to meet short-term obligations without relying on inventory sales.

   Quick Ratio=Current Assets−InventoryCurrent Liabilities\text{Quick Ratio} = \frac{\text{Current Assets} – \text{Inventory}}{\text{Current Liabilities}}Quick Ratio=Current LiabilitiesCurrent Assets−Inventory

   • A more stringent measure than the current ratio because inventory may not be as easily liquidated.

Solvency Ratios (Measure the company’s ability to meet long-term obligations)

1. Debt-to-Equity Ratio: Shows the proportion of company financing that comes from debt versus equity.

   Debt-to-Equity Ratio=Total LiabilitiesShareholder Equity\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholder Equity}}Debt-to-Equity Ratio=Shareholder EquityTotal Liabilities

   • A higher ratio indicates more leverage (debt), while a lower ratio suggests the company is primarily equity-financed.

2. Debt-to-Assets Ratio: Measures the percentage of a company’s assets financed by debt.

   Debt-to-Assets Ratio=Total LiabilitiesTotal Assets\text{Debt-to-Assets Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}Debt-to-Assets Ratio=Total AssetsTotal Liabilities

   • A lower ratio is preferred, indicating that a company is using less debt to finance its assets.

3. Equity Multiplier: Reflects the proportion of a company’s assets that are financed by its equity.

   Equity Multiplier=Total AssetsTotal Equity\text{Equity Multiplier} = \frac{\text{Total Assets}}{\text{Total Equity}}Equity Multiplier=Total EquityTotal Assets

Return Ratios (Measure the return on investments for shareholders)

1. Return on Equity (ROE): Measures how effectively management is using a company’s assets to create profits for shareholders.

   ROE=Net IncomeShareholders’ Equity\text{ROE} = \frac{\text{Net Income}}{\text{Shareholders’ Equity}}ROE=Shareholders’ EquityNet Income

2. Return on Assets (ROA): Indicates how efficiently a company is using its assets to generate profit.

   ROA=Net IncomeTotal Assets\text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}}ROA=Total AssetsNet Income

Additional Considerations

• Depreciation and Amortization: Depreciation refers to the reduction in value of tangible assets like equipment and buildings over time. Amortization applies to intangible assets, such as patents.

• Working Capital: This measures a company’s operational liquidity and is calculated as:

  $$\text{Working Capital}=\text{Current Assets}-\text{Current Liabilities}$$

  Positive working capital indicates that a company can cover its short-term liabilities with its short-term assets.

• Leverage: Leverage is the use of borrowed funds (debt) to increase the potential return on investment. While leverage can amplify profits, it also increases risk.

Off-Balance-Sheet Items

Certain obligations and assets may not be recorded directly on the balance sheet but can significantly impact the company’s financial position:

• Operating Leases: Leases that do not result in asset ownership are often not recorded as liabilities but may still represent long-term commitments.
• Contingent Liabilities: Potential liabilities that may occur depending on the outcome of future events, such as lawsuits or warranties.

Sample Structure: