Understanding Financial Statements: The Balance Sheet

The balance sheet is important to business operations in general. It provides a snapshot of what the company owns and what they owe to outside sources. The balance sheet is also known as a profit and loss account. By either name, this special form of financial statement provides great insight into an organization’s holdings.

Breaking Down the Balance Sheet

To clarify, a balance sheet shows how much money the organization has, how much property they own, and most importantly, how much money they owe. This is beneficial for outside sources to view – bankers, investors, and even potential creditors.

The balance sheet is broken down into several sections. Each section is grouped by liquidity – that is, how easily the particular asset can be converted into cash. The first section is short term assets. Within this category, cash is listed first, followed by near cash assets. Near cash assets are assets that can be easily converted into cash. Accounts receivable, money that people owe the organization, is also listed in this category.

The next category is the long term assets. These would include equipment, property, and buildings, along with long term accounts receivable. Generally, long term assets are assets that cannot be easily converted to cash within a year’s time.

After long term assets comes the liabilities category. This category is also divided into short and long term – that is, short and long term liabilities. In this case, time is generally defined in years – less than a year for short term, and more than a year for long term.

Short term liabilities would include items such as mortgage payments for the next year, along with utilities and equipment leases. In addition, short term liabilities include employee wages, usually listed as wages payable. Long term liabilities would include items such as the remainder of the mortgage for future years, along with equipment leases. Items here overlap, as time is the separator, not the specific item.

Uses of the Balance Sheet

The balance sheet is used internally to gain insight into what the company has available at a certain point in time. Potential creditors to use a company’s balance sheet to determine the cash to debt ratio, which would in turn inform them how much risk is involved in lending. Investors can use a company’s balance sheet to judge risk as well. For example, if a company is cash heavy or cash light, this could be an indicator of problems within the company. Size of the balance sheet is also an important factor in determining corporate health. If the balance sheet is large, this is an indicator of lots of activity, which may indicate positive growth. On the other hand, if the balance sheet is small, it may mean that the company is growing stagnant.

Flow and Format of Balance Sheets

The balance sheet is laid out in a specific order for a number of reasons. The first reason is GAAP, or Generally Acceptable Accounting Practices. It is a guideline used by all accountants to formalize the statements and keep communication standardized. If the company is also publicly traded, then the format of the balance sheet is required by the SEC, the Securities and Exchange Commission. The last reason relates to Sarbanes – Oxley, a set of accounting regulation regarding internal controls designed to minimize fraud. Due to recent corporate scandals, such as Enron and WorldCom, regulations have been stricter, requiring more detail.

In short, balance sheets provide insight into a company’s holdings for all to see. Balance sheets are a highly informative tool, often open for public viewing if the company is traded publicly. Without balance sheets, it becomes difficult to gain a clear insight into the health of the company.