As the balance sheet’s name implies, assets must be equal to liabilities plus shareholders’ equity.
What Is the Balance Sheet?
The balance sheet lists a company’s assets, liabilities, and shareholders’ equity–all of which show its financial position for a period. It is also called the statement of financial position. The balance sheet is one of the three main components of a company’s financial statement; the other two being the income statement and the cash flow statement.
Assets, liabilities, and shareholders’ equity are the main components of the balance sheet. Assets show how a company uses its capital, while liabilities and shareholders’ equity show its sources of capital. And a company’s balance sheet is what its name implies: Assets must equal liabilities plus shareholders’ equity.
Assets include accounts receivable, inventories, properties, plants, equipment, cash and other items that can be converted into cash, while liabilities include accounts payable, deferred revenue, and long and short-term debt. Shareholders’ equity–the difference between assets and liabilities–includes items such as retained earnings, and capital stock. All of the line items are in keeping with generally accepted accounting principles (GAAP).
For publicly traded companies, the balance sheet is found in the financial statement filed quarterly and annually with the Securities and Exchange Commission.
Why Is the Balance Sheet Important?
The balance sheet provides a snapshot of a company’s financial strength, and there are many ways to interpret the data. It can show how a company utilizes its capital based on its assets, and how debt can hinder its investment and growth opportunities. For example, a company having more assets than liabilities suggests that it’s highly solvent and be able to deploy its capital to buy companies, invest in its workforce and facilities, and put aside some money into marketable securities.
On the flip side, negative shareholders’ equity could show that the company’s accumulated losses exceed its capital stock, which could indicate that it’s on the brink of bankruptcy. Companies that recently went public and have yet to turn out a profit are likely to have accumulated losses, but are positive with their capital stock.
What Does the Balance Sheet Show?
Items on the balance sheet can be used to show various metrics that are helpful for investors in interpreting a company’s financial position.
Debt-to-Equity Ratio
One key metric is the debt-to-equity ratio, which indicates how much leverage a company has. That’s calculated by dividing liabilities by shareholders’ equity.
A high ratio suggests a company has taken on a lot of debt and would take a long time for its debt to be repaid. That could also mean that a company would have to use more of its cash on debt repayment instead of deploying its capital for investment and other opportunities.
Debt-to-Equity Ratio = Shareholders’ Equity / Liabilities
Current Ratio
The current ratio indicates a company’s solvency. It is calculated by dividing assets by liabilities. A ratio of 1 or greater suggests that a company is able to meet its financial obligations. A ratio much lower could indicate that a company is taking on more debt than it could easily service.
Current Ratio = Assets / Liabilities
Liabilities-to-Assets Ratio
The liabilities-to-assets ratio indicates how much a company owes relative to what it owns. It is calculated by dividing liabilities by assets. A low ratio could indicate that a company is keeping its borrowings in check and is able to repay its debt on time. Meanwhile, a high ratio could mean that–like with a high debt-to-equity ratio–a company is using much of its cash in servicing debt.
Liabilities-to-Assets Ratio = Liabilities / Assets
What Are the Limitations of the Balance Sheet?
Examining a company’s balance sheet is only one piece of understanding a company’s financial strength. It doesn’t show a company’s ability to generate a profit as the income statement does. It also doesn’t show how much cash a company holds and how it’s deploying the cash, which can be found in the cash flow statement.
As capital stock in shareholders’ equity shows, not all items entered in the balance sheet are recorded at fair value because of the use of an accounting method known as lower of cost or market (LCM), which looks at an asset’s fair value and its costs but takes the lower value. That’s particularly true with inventories that have been held for a long time, to ensure assets aren’t overinflated.
Fair value for some items differs from market value in that the value of an asset isn’t determined by market prices. The market price for inventories might be difficult to set because prices aren’t always readily available and must be agreed upon between buyer and seller, compared to stocks and bonds, where prices are typically set by the market and are readily available.
If a company were to sell all of its assets, it’s unlikely that proceeds from the sales would match book value. Still, the items in the balance sheet serve as a useful guide on how a company is managing its assets and liabilities.
Balance Sheet Example: Apple (NASDAQ: AAPL)
Below is Apple’s balance sheet for 2020–2021, which shows assets equivalent to liabilities and shareholders’ equity. Total assets, liabilities, and shareholders’ equity show it’s in a strong financial position. Assets exceed liabilities, which suggest that Apple is able to meet all of its financial obligations.
By selling a portion of its marketable securities, for example, the company would be able to pay off all of its short and long-term debt, and it could still generate some profit with its remaining securities. At the same time, its large stockpile of cash on hand could meet any immediate payment.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about the balance sheet.
Can the Balance Sheet Be Negative?
Probably that is meant to ask about negative shareholders’ equity, which is liabilities exceeding assets. Having negative shareholders’ equity could mean that the company is unable to meet its financial obligations and is insolvent.
How Does the Balance Sheet Compare to Income Statement and Cash Flow Statement?
The balance sheet shows what a company owns and owes. In comparison, the income statement shows a company’s ability to generate profit, and the cash flow statement shows how it makes and spends its cash.
