What’s it: A balance sheet presents the company’s current financial position. It consists of three subparts: assets, liabilities, and shareholder equity. Also called a statement of financial position or a statement of financial conditions.
The balance sheet provides a brief overview of the health of the company. It is useful to assess the company’s financial position and evaluate its ability to meet short-term and long-term obligations.
If the company has many assets relative to liabilities, it is in good condition. Conversely, if the company has significant obligations, it will cost the company’s money.
What the balance sheet shows
The balance sheet includes three basic components, namely, assets, liabilities, and shareholder equity.
- Assets represent the resources that are owned by the company and are used to generate profits.
- Liabilities or liabilities are claims for these resources
- Owner’s equity or shareholder equity is the shareholder’s residual claim on company assets after deducting liabilities.
The relationship between the three is presented in the following basic accounting equation :
Assets = Liabilities + Owner’s equity
What are assets
Companies usually present assets into two parts based on their liquidity order:
The company expects to convert current assets during the normal operating cycle (usually one year). They include cash and cash equivalents, securities, accounts receivable, and inventories.
Cash and cash equivalents – consisting of cash and banks, as well as low-risk and highly liquid investments such as money market funds. Companies can convert cash equivalents quickly with little or no price risk.
Marketable securities – including investments in bonds or other securities with maturities of less than one year. Such investments produce higher returns (though less liquid) than cash equivalent.
Accounts receivable – appears when the company sells on credit, i.e. the company has sent the goods or services provided. Still, the customer has not paid for it. Because some customers tend not to pay, the company reports it as net receivables, i.e., the gross value of trade receivables less allowance for doubtful accounts.
Inventory – including raw materials, semi-finished products, and finished products waiting to be sold. This account is important for you to pay attention to, especially for manufacturing and retail businesses. Suppose the inventory level grows much faster than the company’s sales. In that case, it increases the expense and forces the company to reduce the selling price. As a result, the company’s profitability will also be lower.
Inventory also binds capital. It would help if you observed how quickly the company could sell its inventory. High inventories, relative to sales, show more money tied to goods in the inventory.
Noncurrent assets – represents the company’s long-term resources. They include fixed assets, long-term investments, and intangible assets.
Long-term investments – an investment of more than one year. Its components might include investments in bonds, property, or shares in other companies. They are less liquid and have a higher price risk than cash and short-term investments.
Property, plant, and equipment (PP&E) – represent the company’s fixed assets and are useful for generating income, including land, buildings, factories, furniture, equipment, and so on. The company reports it as net value, that is, reduces it by accumulated depreciation, i.e., the total depreciation recorded on an asset over its useful life.
Intangible assets – such as goodwill. If the company reports depreciation for fixed assets, the company reports amortization costs for intangible assets.
What are liabilities
Like assets, the presentation of liabilities is based on the order of liquidity: current liabilities and noncurrent liabilities. Current liabilities are liabilities that will mature in one year. Examples are accounts payable and short-term debt. Meanwhile, examples of noncurrent liabilities are long-term debt and deferred tax liabilities.
Short -term debt – is interest-bearing debt with a maturity of less than one year. High short-term debt reduces a company’s flexibility in using cash because it has to pay back relatively quickly, which could cause liquidity problems.
Accounts payable – arises when a company has received goods or services from a supplier but has not paid for them. It is the opposite of accounts receivable. Therefore, if it can delay payments to suppliers without problems, it has higher flexibility in using cash.
Long -term debt – is money borrowed by companies with a maturity of more than one year. An example is a bank loan or bond. Long-term debt reduces a company’s financial flexibility because the company must pay interest regularly.
To evaluate whether the debt is a problem or not, you can compare interest payments with the money the company generated from operating activities.
Meanwhile, the company also records a portion of its long-term debt due within one year as a current liability. Say, the company borrowed Rp500 million for five years and around Rp20 million due this year. The company will report to current liabilities of Rp20 million.
What is shareholders’ equity (or owners’ equity)
Shareholders’ equity consists of components such as paid-in capital, additional paid-in capital, retained earnings, accumulated other comprehensive income, and treasury shares. Suppose a company invests a portion of net profit as capital. In that case, it will go into retained earnings, representing an accumulated net income that is not distributed to shareholders as dividends.
How to link the balance sheet with the cash flow statement and the income statement
The accounting equation shows you that if a company’s assets change, equity or liabilities must also change. For example, when a company sells products in cash, it increases cash (assets). At the same time, the company also posted an increase in shareholders’ equity through the retained earnings component. Suppose the sale is made on credit, then before being paid. In that case, the company will record trade receivables on current assets and revenue in the income statement (an increase in retained earnings).
Ending cash and cash equivalents + Non-cash assets = Liabilities + Contributed capital + Initial retained earnings + Net income – Dividends
Where ending cash and cash equivalents is equal to initial cash and cash equivalents plus net cash flow. Net cash flow is equal to the amount of net cash flow from operating, investing, and financing activities. You can find it on the cash flow statement.
Meanwhile, net income is at the bottom line of the income statement. It is total revenue minus total expenses. For dividends, you can find it on the cash flow statement.
Why the balance sheet is important
This report tells you whether the company can pay liabilities on time or no. Liquidity is the fulfillment of short-term obligations. Meanwhile, the ability to pay off long-term obligations is called solvency. You can use financial ratios such as current ratio, cash ratio, debt to asset ratio, and debt to capital ratio in the evaluation of both.
The balance sheet is also useful for knowing the financial flexibility of a company to get capital. Financial flexibility becomes essential when companies need external capital to grow their business. If the company has a high level of debt (leverage), it limits the company to take new loans. The company must pay interest and existing principal before getting new debt.