The balance sheet of a company is one of the most essential financial statements it will issue—usually annually, quarterly or even monthly in some cases, depending on how often it is reported.
Have you ever been in a situation where you needed to construct a balance sheet? Here’s all you need to know about balance sheets, including how they function and why they’re important in business, as well as the broad steps you can take to prepare one for your company.
What is a Balance Sheet?
A Balance sheet is a statement drawn up at the end of each financial period showing the various assets, liabilities and capital of the business in a well arranged and systematic form.
The balance sheet is drawn up at a certain date and it is not an account. It is divided into two equal parts, showing on the left liability or owner’s equity, while on the right side, the assets.
Information Disclosed By On Balance Sheet
The information about the business which are disclosed by the balance sheet are:
- The nature and extent of the assets.
- The solvency of the business.
- The nature of liabilities.
- Information as to over or under trading.
Components Of A Balance Sheet
What are the 3 main things found on a balance sheet? The three basic parts of a simple balance sheet are assets, liabilities and capital (owner’s equity). These components will be explained as you read.
The balance sheet equation is given below as:
Assets = Liabilities + Shareholders’ Equity
Assets can be defined as the resources, properties or possession of a firm. They are owned by a company and are expected to be of some future benefits. Examples of assets are: land and building, furniture and fittings, motor van, cash, bank, stock of goods, etc.
Types Of Assets
There are two types of assets: fixed assets (non-current) and current assets.
Also known as non-current assets, fixed assets are long-lasting assets, which are purchased for the purpose of creating productive capacity. They are permanent in nature and can last for a very long time. They are acquired for use within the organization and not for sale to customers. Examples of fixed assets are land and building, plant and machinery, furniture and fittings, premises, equipment, motor vehicles, etc.
Characteristics of fixed assets
- They are long-lasting
- They are not bought for resale
- Held purposely to earn revenue
- Expenditures incurred on fixed assets are capital in nature.
These are assets which are usually held for a short period of time for the purpose of conversion in the ordinary course of business. Examples of current assets are stock of goods, cash in hand, cash at bank, bills receivables, debtors, etc.
Characteristics Of Current Assets
- Held for resale at profit
- Have a short lifespan
- Easily realizable
Other Classifications of Assets
Assets can be classified as tangible and intangible assets, liquid assets, fictitious assets, wasting assets.
- Tangible Assets: These are assets that can be seen, felt and touched. Examples are; land, machinery, equipment, etc.
- Intangible Assets: These are assets which have no physical substance but contribute economic benefits to business. They are simply assets that we can’t see, feel or touch. Examples are goodwill, trademark, patent, copyright, etc.
- Liquid Assets: These are assets which can easily be converted to cash. An example is security.
- Fictitious Assets: These are assets of unusual character, which resemble those of assets. They are merely debit balances, which are not realizable. Examples are preliminary expenses, etc.
- Wasting Assets: These are assets that are used up over a period of time. They become exhausted from being worked upon. Examples are mines, timber, crude oil, tin, gold, etc.
Liabilities are obligations arising from past transactions. It is a claim by the outsider on the assets of the business. It also means the indebtedness of an organization to outsiders. Examples of liabilities are: debenture, loans, overdraft, creditors, etc.
Type of Liabilities
There are two types of liabilities: long-term liabilities and current liabilities.
- Long-term Liabilities: These are liabilities which become due for settlement after more than one year. Examples of long-term liabilities are debentures, bonds, etc.
- Current Liabilities: These are liabilities which are due for settlement within one year. They’re paid within a short period of time (one year or less). Examples of current assets are creditors, overdraft, accrued expenses, income in advance, etc.
Characteristics Of Current Liabilities
- They’re payable within one year.
- They’re owed to outsiders.
- Contingent Liabilities: These are obligations which will arise in future only through a specified event. It can also be defined as a condition which exists at the balance sheet date where the outcome will be confirmed only on the occurrence or non-occurrence of one or more uncertain events. Examples of contingent liabilities are bills receivable discounted.
Capital is the original money invested in a business by the owner. It is also referred to as net worth or owner’s equity. In short, it is the total resources in cash which are used to establish a business.
Types of Capital
- Equity capital: This is the amount contributed by the shareholders plus any retained earnings
- Loan capital: Loan capital is the total amount of money that the business borrowed from external sources. Examples are debenture, bonds, etc.
- Working capital: This is the excess of current assets over current liabilities. It is the capital required for the day-to-day running of the business.
- Capital employed: Capital employed is the excess of total assets over current liabilities.
Can A Balance Sheet Be Out Of Balance?
A balance sheet should never be out of balance, it should be balanced at all times. The name balance sheet, is derived from the fact that a company’s assets are equal to its liabilities plus any issued shareholders’ equity. However, if your balance sheet isn’t genuinely balanced, it could be due to one of the following factors:
- Incomplete data
- Transactions were entered incorrectly
- Currency exchange rate errors
- Errors in inventory
- Wrong equity calculations
- Wrong loan amortization or depreciation
How To Prepare Balance Sheet
How do you prepare a balance sheet? The steps to creating a simple balance sheet for your business are outlined here. Even if you use accounting software to automate some or all of the process, knowing how a balance sheet is generated can allow you to recognize errors and correct them before they cause long-term damage.
The steps to preparing a balance sheet for your business are:
1. Decide on the reporting date and time-frame
A balance sheet is used to show a company’s total assets, liabilities, and shareholders’ equity as of a specified date, known as the reporting date. The reporting date is frequently the last day of the reporting period.
The first step to preparing a balance sheet is to decide on the reporting date.
The majority of businesses, particularly those that are publicly traded, will report on a quarterly basis. In this case, the reporting date will almost always fall on the last day of the quarter:
- First quarter (Q1): March 31
- Second quarter (Q2): June 30
- Third quarter (Q3): September 30
- Fourth quarter (Q4): December 31
Businesses that report annually typically select December 31st as their reporting date. However, they can use any date they want.
2. Determine Your Assets
Assets are often listed on a balance sheet in two ways: as individual line items and, secondly, as total assets. Dividing assets into multiple line items will enable analysts to comprehend what they are and where they came from; total them for final asset analysis.
Assets will often be split into the following line items:
- Cash and its equivalents
- Short-term marketable securities
- Accounts receivable
- Tangible and intangible assets
It’s important to remember that both fixed and current assets should be subtotaled before being added together.
3. Determine Your Liabilities
You’ll also need to figure out what your liabilities are. These should also be sorted into line items and totals, as seen below:
- Accounts payable
- Accrued expenses
- Deferred revenue
- Other current liabilities
- Deferred revenue (non-current)
- Long-term lease obligations
- Long-term debt
- Other non-current liabilities
Liabilities should be subtotaled and then summed together, much like assets.
4. Determine Shareholders’ Equity
When a business is privately owned by a single person, calculating the shareholders’ equity is usually easy. If the company is publicly traded, the computation may get more complicated due to the many forms of stock that have been issued.
The following are examples of line items seen on the shareholders’ equity part of the balance sheet:
- Common stock
- Preferred stock
- Treasury stock
- Retained earnings
5. Add Total Liabilities to Total Shareholders’ Equity and Compare to Assets
To guarantee that the balance sheet is balanced, subtract the total of liabilities and owner’s equity from the total assets. That is:
Total assets – (Liabilities + Equity)
Here’s a simple balance sheet format:
The balance sheet of a company is one of the most important financial statements, providing a fast overview of the company’s financial health. Learning how to prepare it and solve problems when they arise will help you become a useful member of your team.
If the balance sheet does not balance, there is most certainly a mistake with some of the numbers that you have used. Check to make sure that all your entries are accurate. You may have underestimated your totals, omitted or duplicated assets, liabilities, or equity in the process.