This article is all about the balance sheet. What is a balance sheet and why it should be reviewed is in the opening section. Later, you will learn about balance sheet reporting, including the assumptions used to represent accounts such as inventory and depreciation. In the next section, you will find the various accounts on the balance sheet, including its example. The last is about how to analyze the balance sheet, including the relevant ratios.
What is a balance sheet?
Balance sheet is the main part of the financial statements in addition to the income statement and cash flow statement, showing the company’s financial position on a certain date. Its other names are statements of financial position or statements of financial condition.
It is divided into three groups: assets, liabilities, and shareholders’ equity. Assets represent the resources owned by the company. Meanwhile, equity and liabilities represent claims on these resources. Thus, all three are linked in the accounting equation: assets = liabilities + shareholder equity.
Guide to Understanding and Analyzing Financial Statements
What is a balance sheet used for? Why is it important?
Combined with an income statement and cash flow statement, a balance sheet is vital for understanding and evaluating how healthy a company’s finances are. It provides a sketch of the company’s financial position. It shows you what the company owns (assets) and who owns it (liabilities and shareholder equity). In it, you can get valuable information and answer some questions such as:
- How much money does the company have at any given point in time?
- How big is the company’s debt, both short-term and long-term?
- How much does the company depend on debt to finance its long-term expansion and to finance its assets?
- How capable is the company of meeting its obligations?
- How good is the company’s financial flexibility to raise additional capital?
- How good is the company’s working capital? Is it negative?
- How much money is owed to the customer?
But, you should interpret the numbers in it with care, especially if you want to compare them to competing companies. The basis for measuring assets and liabilities can vary widely between companies. Companies have some flexibility. That’s a significant impact on the reported figures, and sometimes, the same make intercompany accounts less comparable.
Then, the balance sheet reflects the financial position at a given time point. The figures in it only reflect the value at the reporting date. So, they do not reflect the current market value. For example, companies typically report acquired land at historical cost. Suppose the price has increased since the acquisition date. In that case, the asset’s value reported on the balance sheet is lower than it would be if current market values were used. Long story short, the balance sheet shows only the book value, not the market value.
How do companies report balance sheets?
Companies may present balance sheets according to report format or account format.
- Report format. The company presents assets, liabilities, and equity in one column. Assets are at the top, followed by liabilities and equity.
- Account format. The company exhibits its assets, liabilities, and equity in two columns. Assets are to the left of the balance sheet. Meanwhile, the other two are on the right side, liabilities on the top, and below are equity.
For accounts in assets and liabilities, companies usually group them into current and noncurrent subcategories. In each subcategory, accounts are presented in liquidity order, with the most liquid accounts, such as cash at the top followed by the least liquid accounts.
Under IFRS, inventories are reported under the cost or net realizable value method, whichever is lower. Inventory costs include purchase costs, conversion costs, and other costs incurred until the inventories are in a condition and place ready for sale or use. Meanwhile, under US GAAP, it is reported using the cost or market value method, whichever is lower.
- Net realizable value equals the estimated selling price minus costs to sell.
Meanwhile, the cost of inventories is calculated using:
- Specific identification method for interchangeable goods for other goods.
- LIFO, FIFO, or average cost method for interchangeable goods for other goods – IFRS only allows the latter two.
Specific identification method recognizes specific items, which items are sold and left in inventory to carry over to the next period. The accountant then assigns costs individually instead of grouping the items together.
First‐In, First‐Out (FIFO) matches sales to the cost of inventory items in the order in which they were placed in inventory. It assumes the first item purchased is the first one sold.
Thus, the company calculates the cost of inventory based on the price of the most recently purchased item. Meanwhile, the cost of goods sold is calculated using the price of the oldest item.
Last-In, First-Out (LIFO) is the opposite of the FIFO method. It assumes the most recently purchased item is the first one sold. Thus, the cost of inventory includes the earliest item. Meanwhile, the cost of goods sold is calculated based on the most recently purchased item.
Weighted average cost method assigns the same unit cost to all units available for sale during the period.
Initially, the company measures fixed assets at its cost. Then, they are measured using the cost model or revaluation model under IFRS and only the cost model under US GAAP. They are then depreciated and allocated as depreciation expenses over their useful life.
- Depreciation expense refers to the estimated decline in the fixed assets’ economic value for a certain period. The company reports it on the income statement. Meanwhile, it accumulates depreciation to reduce the fixed assets presented on the balance sheet.
The depreciation method allocates the cost of fixed assets such as plants and equipment over their estimated useful lives.
Straight-line depreciation allocates depreciation expense evenly over the estimated useful life. To calculate depreciation expense, you first calculate the difference between the asset’s cost and salvage value. Then, you divide the result by the asset’s useful life.
Depreciation expense = (Cost – Salvage value) / Useful life
Accelerated method allocates a relatively large proportion of the cost of an asset to the early years of its useful life. In other words, it records more depreciation expense in the early years of the asset’s life, resulting in lower reported net income than the straight-line method. An example is the double-declining balance method.
- Double-declining balance method applies double the straight-line depreciation rate times the declining book value (acquisition cost less accumulated depreciation).
Depreciation expense = (2 / Useful life) * (Cost – Accumulated depreciation)
Financial instruments refer to monetary contracts between two entities. They can be financial assets or financial liabilities. Financial assets can be receivables and investments in securities such as stocks and bonds. Meanwhile, the financial liability may be the bonds and notes payable.
- Derivative instruments are financial instruments in which their price is derived from the underlying asset’s price. Examples are options, forwards, futures, and swaps. Meanwhile, the underlying assets can be stocks, bonds, indices, or commodities.
The three groups of financial assets are:
Available-for-sale securities are securities for which a company is willing to sell but is not actively planning to sell. The company presents them on the balance sheet at fair value. Meanwhile, for unrealized gains, the company includes it in the other comprehensive income.
- Mark-to-market is a process to measure and adjust assets or financial liabilities at current market value or their fair value. It provides a realistic assessment of actual conditions.
Held-for-trading securities refer to securities purchased for sale shortly, usually less than one year. As long as it is held, the company expects its value to appreciate to be sold at a profit.
- Companies report them at fair value on the balance sheet. Meanwhile, the company presents interest income, dividend income, realized gains and losses, and unrealized gains and losses in the income statement.
Held-to-maturity securities refer to debt securities owned by a company and held to maturity. On the balance sheet, the company presents it at amortized cost. The amortized cost is equal to the nominal value of the securities less unamortized discount plus unamortized premium.
- The company does not recognize unrealized gains and losses in the income statement. It only recognizes these gains and losses when the securities are sold.
How to read a balance sheet? What are the items in it?
Basic formula for a balance sheet is:
Assets = Liabilities + Equity
We call this mathematical equation the accounting equation, showing that when assets change, at least the liabilities or equity must also change. The formula above is essential when building a full financial model, linking the balance sheet to the income statement and cash flow statement.
The balance sheet is linked to the statement of cash flows through the cash and cash equivalent accounts. The equation is this:
- Assets = Non-cash assets + Ending balance of cash and cash equivalents.
- Assets = Non-cash assets + Beginning balance of cash and cash equivalents + Change in net cash.
- Assets = Non-cash assets + Beginning balance of cash and cash equivalents + Net cash from operating activities + Net cash from investing activities + Net cash from financing activities.
Meanwhile, the income statement is connected to the balance sheet through retained earnings.
- Equity = Other equity components + Ending retained earnings
- Equity = Other equity components + Initial retained earnings + Net income – Dividends
Assets show the economic resources owned by the company. They provide economic benefits to the company, which can be cash inflows or other economic benefits. When does the company get the economic benefits? Assets are then grouped into two categories:
- Current assets. Also known as short-term assets.
- Noncurrent assets. Also known as long-term assets.
Current assets flow economic benefits to the company in one operating cycle, usually defined as one year. The company expects to use them or convert them into cash in the next 12 months.
When reading the financial statements, you may find the following accounts in current assets:
- Cash and cash equivalents
- Marketable securities
- Accounts receivable
- Prepaid expenses
- Deferred tax assets
The company does not show several immaterial accounts separately; instead, they are combined into one account, other current assets.
Cash and cash equivalents – the most liquid assets and are listed on the top row of assets. It includes two sub-accounts, a cash account, and a cash equivalent account. Companies usually present both on one line as cash and cash equivalents.
- Cash represents the most liquid assets, including money on hand and on deposit in banks.
- Cash equivalents are short-term investments in highly liquid instruments. They are close to cash and readily convertible to known amounts of cash. They are of high quality, mature in less than 90 days, and when interest rates change, they are less likely to change in value. They are measured at amortized cost or fair value, both of which usually yield quite similar figures.
Marketable securities – investments to be resold shortly and have a market available for them. They can be stocks, bonds, or options, which can be easily sold in the short term. The company holds them for a return on temporarily unused cash. It reports them at market price. Also known as a short-term investment.
Accounts receivable – amounts owed by customers to the company. This account appears when the company has delivered goods or provided services to customers but has not received payment until the end of the reporting date.
- The company reports account receivable on the balance sheet at net realizable value, adjusted for the allowance for doubtful accounts (a contra account).
- Receivable means the amount owed by a third party, maybe a customer or noncustomer. It can be the trade receivables and non-trade receivables such as income tax receivables and insurance claims receivables.
- Trade receivables are usually used interchangeably with accounts receivable. It refers to any receivables generated by selling products or providing services to customers.
Inventories – company merchandise, raw materials, semi-finished goods, work in process, and unsold finished products. They may be in the warehouse or still on the production line.
- This account is strategic for businesses such as manufacturing and retail. Say the value continues to increase from year to year. It may indicate the company makes or buys more goods than can be sold. It ultimately leads to lower profits.
Prepaid expenses – arise when the company has paid suppliers but has not received goods or services. It gives an inflow of economic benefits in the future but does not involve cash inflows. Thus, when calculating liquidity ratios such as the quick ratio, it is excluded.
Deferred tax assets – arise when excess amounts are paid relative to accounting profit. Taxable income exceeds accounting profit, and income tax payable is higher than tax expense. The company expects to recover the difference in the future when the tax expense exceeds the income tax payable.
Noncurrent assets are expected to bring economic benefits for more than one year. Like current assets, they are usually broken down into accounts such as fixed assets, long-term investments, and intangible assets.
Long-term investments – the company’s investments in various asset classes – such as property, stocks, bonds – that the company owns for more than one year. Unlike short-term investments, companies may not sell them for years and, in some cases, may never be sold.
- Investment property – property purchased for rental income, capital appreciation, or both. It differs from the property for operating activities such as office buildings.
Property, plant, and equipment (PP&E) – refers to the company’s fixed assets. They represent tangible noncurrent assets and are used by companies in operating activities to generate revenue. Items may include land, manufacturing facilities, buildings, machinery, furniture, and capital equipment.
Intangible assets – assets without physical substance but provide economic benefits to the company. They include patents, copyrights, export licenses, trademarks, and purchased goodwill.
- If they have an indefinite useful life, they are not amortized but are tested for impairment. Meanwhile, those with finite useful lives are systematically amortized over their life, similar to depreciation for fixed assets, except that there is no residual value.
- Goodwill is divided into accounting goodwill and economic goodwill. The former is reported on the balance sheet, whereas the latter is not.
- Accounting goodwill arises when a company acquires another company and pays more than the target net asset value. In other words, it represents the premium paid by the company. Acquirers are willing to buy at a premium because the target firm owns various intangible assets such as brand equity, corporate image, customer relations, and patents, contributing to making money in the future.
- Economic goodwill comes from the company’s internal development, not from acquisitions. Although it is not reflected in the balance sheet, it is strategic because it affects its performance and future prospects.
Liabilities are existing obligations where the settlement results in an outflow of resources, which can be a decrease in economic benefits or a creditor’s claim to the company’s resources. They include accounts payable, prepaid revenue, short-term debt, tax payable, and long-term debt. On balance sheets, companies usually present them into two subcategories:
- Current liabilities or also known as short-term liabilities.
- Noncurrent liabilities or also known as long-term liabilities.
Current liabilities represent the company’s obligations which are expected to be paid or settled within one year. They include accounts payable, accrued liabilities, deferred income, short-term debt, and a portion of long-term debt maturing within one year.
Short-term debt – a financial obligation to be repaid within one year, usually a bank loan. Other similar terms are current borrowing and short-term borrowing.
- Together with the current portion of long-term debt, short-term debt comes from financing activities. So you should exclude both when calculating net cash from operating activities.
Notes payable – a promise to pay a certain amount at a predetermined time. It is issued to pay off debts or pay for purchases. It can be a short-term liability or a long-term liability, depending on when it is expected to be settled. Furthermore, it often has an interest (though some may not).
Accounts payable – arises when a company purchases inputs on credit and has not paid them until the balance sheet reporting date. The supplier has delivered goods or provided services. Thus, the company has an obligation to pay for it.
- Trade payables are usually used interchangeably with accounts payable.
- Payable represents the amount to be paid. It includes not only accounts payable but also items such as salaries payable and notes payable.
Unearned revenue – appears when a company has received payment but has not delivered goods or services at the end of the accounting period. Also known as deferred revenue, deferred income, or unearned income.
Dividend payable – recognized at the time of dividend announcement but has not been paid until the reporting date. That applies to cash dividends or property dividends, not to stock dividends.
Current portion of long-term liabilities – the unpaid amount of long-term liabilities and will mature in the next 12 months. It can come from bank loans, bonds, or lease obligations. Suppose there are still outstanding debts with maturities of more than one year. In that case, the company presents them as long-term liabilities.
Income tax payable – the amount of income tax owed by the company in the reporting year. The authority calculates the tax levied based on taxable income. Hence, it may differ from the income tax expense calculated on the income statement.
- Suppose the company’s calculation is lower than the authority’s calculation. In that case, it produces an income tax payable, representing the company’s obligation to pay it after the reporting date.
Accrued liabilities – arise when the company has received goods or services but has not paid them at the end of the reporting date. Sometimes take the name accrued expense.
Noncurrent liabilities are expected to be settled in more than one year. However, some liabilities may mature within the next 12 months, so they are presented as current liabilities rather than noncurrent liabilities.
Long-term debt – debt with maturities of more than one year. It could be a bank loan or a bond.
- Noncurrent portion of long-term debt is part of long-term debt and is expected to be repaid within one year from the reporting date.
Deferred tax liabilities – arise when taxable income is less than accounting profit and income tax payable is less than tax expense. The company expects to reduce it in the future when the income tax payable exceeds the tax burden.
Equity represents the residual claim on the company’s assets after deducting its liabilities. In other words, it refers to anything that belongs to the owner after any liability is accounted for. The largest components are usually contributed capital and retained earnings. Also known as owners’ equity, shareholders’ equity, or net worth.
Contributed capital – capital obtained from shareholders or owners. Shareholders inject capital into the company by buying the offered common stock. Also known as paid-in capital, common stock, or issued capital.
- Additional paid-in capital is the investment by shareholders in excess of par value shares. It arises when investors buy shares directly from the company at the initial public offering and pay the price over the par value of the shares. For example, suppose a company issues 1,000 shares with a par value of IDR20 at a price of IDR50, then IDR30,000 = (IDR50 – IDR20) x 1,000 is reported as additional paid-in capital in shareholder equity. Also known as contributed capital in excess of par.
- Common shares – proof of ownership in a company where the holder has voting rights and rights to the assets and dividends paid.
- Authorized shares – the maximum number of shares a company can issue and sell to the public without changing its articles of association.
- Issued shares – the number of shares sold or transferred to shareholders.
- Outstanding shares – the number of authorized shares of equity capital sold to the public and owned by shareholders. It is equal to the number of shares issued minus the treasury shares.
Preferred shares – shares without voting rights but have a higher priority than common stock in claiming dividends and company assets. The company distributes dividends to preferred stockholders before common stockholders. This priority also applies to the distribution of assets upon liquidation.
Treasury shares – outstanding shares repurchased by the company. The repurchase causes the number of shares and owner’s equity to decrease. As a result, the company presents it in equity capital with a negative sign, reducing the common share capital.
Retained earnings – equal to the net profit earned by the company minus dividends. In other words, the company does not distribute all net income as dividends but is retained in the company as equity capital. It’s a cumulative number. Its ending balance is equal to the initial retained earning balance plus net income minus any dividends distributed. Also called undistributed earnings, undistributed profits, or retained profits.
Accumulated other comprehensive income – cumulative other comprehensive income figures, such as unrealized gains and losses on available-for-sale investments.
Minority interest – an ownership interest with less than 50% of the voting rights in a company. Also known as non-controlling interests.
From the items on the balance sheet, you can also get key indicators for analyzing financial statements: working capital and capital.
Working capital – the difference between current assets and liabilities. It is vital to finance the day-to-day operating functions of the company without having to raise funds from debt or equity. Low working capital can indicate financial difficulties, where the company may not meet its short-term obligations.
Working capital = Total current assets – Total current liabilities
- Net working capital is calculated by excluding cash and cash equivalents and short-term debt. It is usually used when calculating cash flows from operating activities using the indirect method, where the formula is net income plus non-cash items on the income statement (such as depreciation and amortization expenses) plus changes in net working capital. Specifically, short-term debt does not come from operating activities but from financing activities.
Net working capital = Total non-cash current assets – Total non-debt current liabilities
The company’s capital consists of debt capital and equity capital. We call this composition the capital structure. Debt only includes interest-bearing debt, both short-term and long-term debt.
- Total capital = Total interest-bearing debt + Total equity
- Total capital = Total short-term interest-bearing debt + Total long-term interest-bearing debt + Total equity
Financial leverage shows you how much a company depends on debt. Suppose it has a high level of leverage. In that case, we say the company has high financial risk, so it may be difficult to meet its debt obligations.
- On the other hand, debt financing offers a low cost of capital because debt interest is tax-deductible.
- Thus, companies will typically combine equity and debt financing to achieve an optimal capital structure, thereby maximizing the firm’s market value while minimizing its cost of capital.
How to analyze the balance sheet?
Ideally, you should analyze the balance sheet along with the income statement and cash flow statement. However, suppose you only analyze balance sheet accounts. In that case, you will get insights such as working capital, liquidity, and solvency. In addition, you can also gain insight into how components on the balance sheet change over time, such as money, assets, debt, and equity.
Let’s standardize the balance sheet above to be as follows:
Horizontal analysis compares accounts on the balance sheet over time, showing how they are increasing or decreasing. You may see the figures from year to year. Or, you use the base year as a comparison for the following year, expressed as a percentage. Say, the base year is 2018, and it is expressed as 100%. Then, the accounts in the next period (2019-2020) are divided by their value in the base year, the result is multiplied by 100%.
Take total assets as an example.
Its value in 2018 was IDR96,538 billion or 100%. Hence, to convert the value in 2019 and 2020, you can calculate it as follows:
- 2019: (96,199/96,538) * 100% = 100%
- 2020: (163,137/96,538 ) * 100% = 169%
Repeat the same calculation for all accounts on the balance sheet. You will get results like the following:
The percentage of total assets is 169%, showing you total assets in 2020 are 169% higher than their value in 2018. In other words, during 2018-2020, total assets have increased by 69% (169% – 100%). Why increase? Check the numbers in each account and mark some accounts with significant figures and then look at the percentages.
The increase mainly came from total intangible assets, which mostly came from goodwill. It increased 1307% from 4,321 in 2018 to 56,463 in 2018, indicating its growing assets through acquisitions.
How the company financed the acquisition. Look at the accounts in liabilities and equity; again, mark the accounts with significant numbers and see the percentages. The most significant account is the noncurrent portion of long-term debt, which increased by 515%. Meanwhile, equity accounts show a percentage less than that. So, we can say, company acquisitions are financed from debt instead of equity.
Vertical analysis expresses each balance sheet account as a percentage of total assets. Thus, it allows us to compare their contribution to the company’s assets from time to time.
The company has 11% of assets in cash in 2020, relatively low compared to the sum of short-term debt plus trade payables (12%). It also appears to be relying on acquisitions to grow in 2020, reflected in the significant increase in goodwill, from 7% in 2019 to 36% in 2020.
The increase in liabilities, especially interest-bearing debt, was higher than equity in 2020. As a result, total liabilities contributed higher, from 44% to 51%. Meanwhile, total equity decreased from 56% to 49%. If you examine the liability items, it can be seen the company is also relying more on interest-bearing debt to grow in 2020. Interest-bearing debt reached 33% of total assets in 2020 – the sum of short-term debt (8%), the current portion of long-term debt (1 %), and the portion of noncurrent long-term debt (24%). This percentage increased from 24% in the previous year.
Ratio analysis is basically similar to vertical analysis – you compare one account to another – but you don’t just use total assets. In addition, you should also add up several accounts into one to provide more meaningful insights, such as total debt and total capital.
The liquidity ratio tells you the company’s ability to meet its short-term obligations. It must have sufficient cash to pay suppliers and repay loans. Three ratios commonly used to measure liquidity are the current ratio, the quick ratio, and the cash ratio.
Current ratio – measures how well the company’s current assets cover current liabilities. It is the loosest liquidity ratio. Current assets include less liquid items such as inventory. Items such as prepaid expenses are also included in the current asset category, although they do not represent future cash inflows. Also known as the working capital ratio.
- Current ratio = Current assets/Current liabilities
A ratio equal to one is the limit, indicating current assets are equal to current liabilities. If it is lower, the company may be experiencing liquidity problems.
Quick ratio – measures liquidity using cash and several other relatively liquid assets. To calculate it, you add up cash, short-term investments, and accounts receivable. Then, you divide it by current liabilities. Also known as the acid test ratio.
- Quick ratio = (Cash and cash equivalents + Short-term investment + Accounts receivable)/Current liabilities
A higher quick ratio is more desirable because the company has sufficient liquidity to meet liabilities maturing in the next 12 months.
It excludes inventory because it is less liquid to convert to cash. Likewise, prepaid expenses are also excluded from the calculation because they do not contribute to cash inflows.
Cash ratio – compares cash and cash equivalents to current liabilities. It is the most conservative liquidity ratio compared to the quick ratio or current ratio.
- Cash ratio = Cash and cash equivalents/Current liabilities
A higher cash ratio is preferable because the company has more cash to meet current liabilities.
Solvency ratio measures the company’s ability to pay off long-term liabilities, especially long-term interest-bearing debt.
Debt-to-equity ratio – shows the extent to which a company finances its operations through equity vs. interest-bearing debt. A higher ratio indicates high financial leverage and is considered risky.
- Debt-to-equity ratio = Total debt/Total equity
Financial leverage ratio – Sometimes referred to as financial leverage multipliers. To calculate it, you divide total assets by total equity.
- Financial leverage ratio = Total assets/Total equity
Total debt ratio – shows how much the company finances its assets from interest-bearing debt. A higher ratio indicates the company is relying on debt to grow assets.
- Total debt ratio = Total debt / Total assets
Debt-to-capital ratio – shows how dependent interest-bearing debt is on its capital composition. You divide the total interest-bearing debt by the total capital. Total capital equals total interest-bearing debt (short term and long term) plus total equity.
- Debt-to-capital ratio = Total debt / Total capital