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

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

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

Components of a Balance Sheet

A balance sheet primarily comprises of the following:

  1. Assets: Assets are tallied on the balance sheet’s left-hand side. Two types of assets are recorded in the balance sheet: 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 to that, long-term assets refer to funds that cannot be accessed immediately by the enterprise. These include property, software, equipment and future investments.

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

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

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 that has been invested by the owners in an enterprise. It is equal to a company’s total assets, excluding the 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 the assets it holds by either 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 by five years, the received money will be recorded by the company’s accounts department under the assets front. Simultaneously, the amount will be tallied under the long-term liabilities account to balance both sides.

Now, if the concerned enterprise can raise Rs. 10,00,000 by attracting investments from shareholders, the same will be added to its assets front and recorded under the stockholders’ equity.

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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 is indicative of the enterprise’s accounting system failure.
  2. The balance sheet allows the investors, managers, regulators, and lenders to know a company’s financial status and some 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 does suffer from 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 that has been 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 often hard to find. But these assets are not documented by 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