What is a Balance Sheet?

A balance sheet is an integral part of the set of financial statements of an organization that reports the assets, liabilities, equity (shareholding) capital, other short and long-term debts, along with other related items. A balance sheet is one of the most critical measures of the financial performance and position of the company, and as the name suggests, the statement must balance the assets against the liabilities and equity. The assets are what the company owns, and the liabilities represent what the company owes. Equity represents the amount invested in the business, either by the promoters of the company or by external shareholders. The total assets must match total liabilities plus equity.

$$Assets=Liabilities+Equity$$

What are the Components of a Balance Sheet?

Assets and liabilities are typically classified into different categories. The major components of a balance sheet are:

Assets

These are all the items that a company owns. This may further be classified into tangible assets and intangible assets based on their liquidity, and fixed assets and current assets based on their period of holding. Let us look at them one by one.

• Tangible assets are those that, as the name suggests, are tangible - seen, touched, and felt. These include assets such as land, buildings, inventory, cash and bank balances, equipment and machinery, computers, vehicles, etc. These are assets that are extremely essential in the day-to-day running of the business.

• Intangible assets are those that cannot be seen and felt. They are, however, important in the functioning of businesses, considering how the world is progressing towards a more technologically advanced cloud-based business model. Intangible assets include goodwill, copyright, trademark, patents, and other intellectual property.

• Fixed assets (or non-current assets/ long-term assets) are those that have been fixed to the land and cannot be moved. They include land, buildings, machinery, and equipment (commonly known as Property, Plant, and Equipment). for classification, intangible assets can also be categorized as fixed assets. Assets mentioned above (except land which tends to appreciate over time) are subject to depreciation (or amortization in the case of intangible assets) which is a measure of wear and tear and obsolescence.

• Current assets are those that are dynamic with constantly changing values, which are expected to be converted into cash within a year. They include inventory, marketable securities, prepaid expenses, cash, and bank balances, and accounts receivable.

Liabilities

A liability represents an obligation by the company to another party. In simple words, liabilities are all items that the company owes to outsiders. They are also further classified into long-term liabilities and current liabilities, based on when they are due. Long-term liabilities (also known as long-term debt or non-current liabilities) are those that are due for more than one year. These include debentures, and other long-term loans (such as those from financial institutions or banks). An asset-backed security is a form of financial instrument that is often backed by a collection of assets, which are usually not liquid by themselves. Any form of income-generating asset may be categorized as asset-backed security, including royalties, home loans, etc.

Equity

Equity (also known as Owner’s or Shareholders' capital/equity) is the amount invested and generated in an organization. Shareholder’s equity represents the net assets which is the difference between assets and liabilities.

A debt-to-equity ratio is a measure of the company’s liabilities against its equity shareholding to determine how much risk the shareholders are exposed to by investing in the company.

Importance of Balance Sheet in understanding Financial statements

A Balance Sheet gives a bird’s eye view of the financial position of the company and is always viewed about other financial statements such as the profit and loss account and cash flow statements, along with important financial ratios (such as debt-equity ratio). It provides relevant and accurate insights on the performance of the company such as liquidity, growth, risk, and efficiency.

Liquidity

An organization’s liquidity can be measured by how many current assets (or liquid assets) it has at its ready disposal, which is an essential metric in terms of financial performance. The balance sheet depicts the number of current assets and current liabilities that are a part of the organization so that shareholders and other stakeholders may make informed decisions. This also has a trickle-down effect on the equity that the organization holds.

Growth and Risk

A balance sheet also denotes the risk appetite and factor of the organization, based on how the decisions of the past year have reflected on the financial position of the company. Generally, the balance sheet snapshots the values for the current financial year and the previous financial year for comparison, which depicts growth and/or highlights problem areas, or points of risk.

Efficiency

By viewing the balance sheet in consonance with other financial statements such as the income/profit and loss statement, one can measure how effectively the organization is using its resources/ total assets while balancing its total liabilities.

Balance Sheet and Compliance

It is always important to ensure that the financial statements represent a true and fair view of the financial information. A Balance Sheet is part of a carefully prepared set of financial statements that are to comply with Generally Accepted Accounting Principles (GAAP) and accounting policies. Also, depending on the type of the organization, there may be a change in the presentation of the financial statements, especially of the balance sheet. In some cases, there may be mergers & acquisitions or joint ventures, or any change to the existing structure of the company. In these cases, the format and presentation of the financial statements change. The balance sheet considers the resulting total assets and total liabilities to repurpose the calculations and present a true and fair view to those seeking the financial information. The liability and equity portions of the balance sheet account for the change in shareholding pattern and the net results are apportioned appropriately to the profit and loss account while disclosing the impact of the changes on the balance sheet.

Formulas

$$\begin{array}{l}Assets=Liabilities+Equity\hfill \\ Debt-equityratio=TotalLiabilities/TotalShareholders’Equity\hfill \end{array}$$

Common Mistakes and Pitfalls

Some of the common errors that are made while preparing the balance sheet and financial statements include:

• Miscalculating or wrongly posting any of the items that make up the balance sheet, which include the following: long-term assets, long-term debt, non-current assets, current assets, and current liabilities.
• Miscalculating the equity portion of the balance sheet which includes critical information on the shareholding pattern and changes to the existing share capital.
• Errors while grouping, clubbing, or splitting line items (from the journal entries, trial balance, profit and loss account, and cash flow statements) that later feed into the balance sheet. This often arises as a result of not following the standard accounting policies or by non-compliance with GAAP.

Context and Applications

This topic is significant in the professional exams for both undergraduate and graduate courses that have accounting and commerce at their core. This may be especially applicable for:

• B. Com
• M.Com
• MBA (Finance)

This topic may also be significant for professional certifications including:

Chartered Accountancy

• Certified Public Accountant (CPA)
• Association of Chartered Certified Accountants (ACCA)
• Certified Internal Auditor (CIA)