The balance sheet is the core of all the financial statements. Therefore, the basic fundamental in accounting and one of the very first equations taught to an accounting student, is derived from the balance sheet. This would be:
Assets = Liabilities + Equity
The balance sheet is based off of this principal and it is considered as the “snapshot of a company’s financials at a specific moment in time”. The statement is called a balance sheet because the two sides balance out. It is simply because the company has to pay for its assets by either borrowing money (Liabilities) or borrowing it from the shareholder/s (Equity).
Assets – can be classified as either current assets, fixed assets or other assets. A current asset would be an asset that would be easily converted into cash, a fixed asset would be an asset that decreases in value over time and an other asset would be an asset that does not belong to both the former groups. A few examples for this are brand name, security deposits and goodwill.
Liabilities – are an obligation to the company and it is credit owed by the company to other institutions or persons. It could be divided into two categories which are short term liabilities and long term liabilities. A short term liability is an obligation of less than 12 months and any obligation over 12 months is a long term liability.
Equity – is referred to as owner’s equity in a sole proprietorship, partners’ equity in a partnership and shareholder’s equity in a corporation. The equity is the residual value in the assets when the debt is paid off to the creditors and when the obligations have been met.
Third parties can grasp an understanding of the financial situation of a company by simply looking at the balance sheet and this becomes the hub to make many important financial decisions. For example, corporations have to present their balance sheet to the board of directors in order to keep them informed about the assets, liabilities and the retained earnings of the company. Investors place a very high importance on the balance sheet because this one statement informs them how much money a company has, how much the company owes and how much money is left for the stockholders. This information can be used to decide whether it would be a benefit or a risk to invest in the company. A bank would decide to lend money or not based on ratios such as the debt to equity ratio and the current ratio, which compares current assets to current liabilities. By analysis they can find out whether the company has the ability to pay off the debt in the future. Other parties that would be interested in the balance sheet are customers, suppliers, current investors, government agencies and labor unions.
When taking into consideration all the above facts it is quite evident that any organization should pay a great deal of attention to the balance sheet. It is important that the organization communicates effectively with its accountant to ensure that all transactions have been recorded properly to reflect the true financial state of the company.
Contributed by Shalini B.