What is Balance Sheet? | Definition, Components, Pros vs Cons

A Balance sheet is essential for analysing an individual’s or an enterprise’s financial status. It is used with other accounting tools like cash flow and income statements to calculate and analyse a company’s financial ratios.

It is primarily a financial statement that provides a snapshot of an organisation’s liabilities, assets and stockholders’ shares at a particular time. This statement offers a basis for assessing an enterprise’s capital structure and calculating the rate of returns.

Key Takeaways

1. A balance sheet is a financial statement that provides a snapshot of a company’s assets, liabilities, and equity at a specific time.
2. The balance sheet is divided into two sections: the assets section, which lists the company’s resources and their value, and the liabilities and equity section, which lists the company’s debts and ownership interests.
3. The balance sheet provides important information about a company’s financial health, including its liquidity, solvency, and overall value.

Components of a Balance Sheet

A balance sheet primarily comprises the following:

1. Assets: Assets are tallied on the balance sheet’s left-hand side. The balance sheet records two types of assets: current assets and long-term assets.

Current assets refer to immediately available funds, such as accounts receivable, cash, future prepaid expenses and inventory. The balance sheet holds the record of these funds for less than one year.

In contrast, long-term assets refer to funds that the enterprise cannot access immediately. These include property, software, equipment and future investments.

• Liabilities: Liabilities are recorded on the sheet’s right-hand side. Like assets, these are classified into current and non-current or long-term liabilities.

Current liabilities refer to the money an enterprise owes and must settle within one year. These include taxes, employee salaries, pending purchase accounts and shareholder dividends.

Non-current liabilities, on the other hand, are the amounts that a company owes and is supposed to pay back over a longer term. These include long-term leases and bank loans.

• Stockholders’ Equity: Also known as ‘net assets,’ it refers to the money invested by the owners in an enterprise. It is equal to a company’s total assets, excluding liabilities.

 Balance Sheet Formula

A balance sheet uses the following formula to evaluate the financial condition of an enterprise.

Assets = Stockholders’ equity + Liabilities

The basis of this formula is that an enterprise is supposed to pay for its assets by attracting investments from the shareholders (stockholders’ shares) or borrowing capital (liabilities).

For example, if an enterprise borrows Rs. 5,00,000 from a bank to be repaid in five years, the company’s accounts department will record the received money under the assets front. Simultaneously, the amount will be tallied under the long-term liabilities account to balance both sides.

If the concerned enterprise can raise Rs. 10,00,000 by attracting shareholder investments, it will be added to its assets front and recorded under the stockholders’ equity.

Advantages of the Balance Sheet

There are several advantages to maintaining a balance sheet. The most prominent among them include:

1. It is effortless to understand as the balance sheet’s objective is to maintain the balance between its liabilities and assets. Any deviation from this goal indicates the enterprise’s accounting system failure.
2. The balance sheet lets investors, managers, regulators, and lenders know a company’s financial status and other financial statements.
3. It helps the companies obtain loans as the banks and other lenders can know their financial position from the company balance sheet.

Disadvantages of Balance Sheet

Despite its varied benefits, a balance sheet has some significant limitations. These include:

1. One cannot directly infer a company’s financial position from the balance sheet. It needs to be compared with the balance sheet of previous years and other companies.
2. The value of the long-term assets recorded under the balance sheet is the cost paid for acquiring those assets, also called book value or historical value. The current value of those assets is not documented in the balance sheet.
3. Only those assets can be recorded in the balance sheet acquired through a transaction. Some assets tend to be too valuable to be expressed in monetary terms, for example, a team of experts whose replacement is hard to find. But these assets are not documented on the balance sheet.

References

1. https://www.tandfonline.com/doi/abs/10.1080/0963818022000001127
2. https://meridian.allenpress.com/accounting-horizons/article-abstract/22/4/453/166294