Why is it called a balance sheet?- Definition, Components, Formula, Examples

Why is it called a balance sheet?

A balance sheet is the most important part of accounting. It is very useful for management. creditors and investors to know the financial health of an organisation. 

They will be able to know the debt-equity ratio, retained earnings, risk areas, and cash flow of the company. 

Why is it called a balance sheet?

A balance sheet is the most important financial statement which includes all information about assets and liabilities of the company for a specific time. A balance sheet has two sides i.e. the assets and liabilities side and for finding out the correctness of this financial statement the total of both the assets and liabilities sides must tally. 

This is one of the most critical three financial statements i.e. cash flow statement and income statement and balance sheet which are used to assess the financial health and performance of an organisation. 

The creditors of the company evaluate whether current assets are greater than current liabilities to know the financial risk the company is bearing and whether it can repay loan instalments 

A balance sheet helps investors, stakeholders and others to know the true financial position of the company so that they can decide whether they should invest in that company. 

It helps in the determination of business liquidity and returns generation rate by comparing current assets and liabilities. It also gives information about the growth of the business by comparing this financial statement (Balance Sheet) at different points in time.

It gives vital information about the business assets, liabilities and shareholders' equity at a given point in time. This financial statement also helps management assess the company's capital structure and the computation of the rate of return for investors. 

A balance sheet helps investors to evaluate a company's creditworthiness and future prospects and by this, the financial institutes and investors decide whether the loan applied by the company can be disbursed or not and whether the money can be invested in that company or not.

Key Factors of Balance Sheet

• It gives the true picture of assets, liabilities and shareholders' equity at a specific point in time.
• It provides a clear picture of the company's financial position at different times.
• Balance Sheet is based on an equation that balance sheet=assets - liabilities - shareholders equity.
• The balance has two sides (assets and liabilities) and the total of both these sides should always be equal.
• The balance sheet is one of the main financial statements of the company (cash flow statement and income statement).
• The basic financial ratio of the company is calculated by analysis of the balance sheet.

A balance sheet gives the true and fair picture of the financial health of the company at a specific point in time. The balance sheet is based on actual data and therefore is not a source of future forecasting. For any financial forecasting, the company has to analyse the previous period data incorporated in those balance sheets.

The balance sheet helps the investors to know the risk factors involved in the financial position of the company by analysing the debt-equity ratio the acid-test ratio and others. The notes to accounts enclosed with the balance sheet provide each and every entry of financial transactions done by the company in a specific period to help all who do business with the company.

Why Balance Sheet is Important?

There are a large number of benefits of a balance sheet regardless of the size or nature of any company. A balance sheet incorporates all the facts and figures about the company's debts and what it owns. It helps investors in risk determination. 

It also helps the finance department, and owners of the company that how much amount they have borrowed and whether there are sufficient funds for its repayment. It gives vital information about the availability of cash in hand to meet the current expenditures without any delay.

A balance sheet is an important document which gives investors, money lenders and financial institutions all the necessary information they require for disbursing loans. The balance sheet also helps in securing the capital of the company. It also helps private investors to invest in private equity. In both these cases, the private investors and the loan-sanctioning authorities make their decisions by assessing the balance sheet.

A large number of financial ratios are taken and used by the top management and finance department of the company to measure turnover, profitability, liquidity and solvency of the company. The valuable employees of the company also rely on balance to decide the financial position, sustainability and profitability of the company to ensure their future in the company.

What are the Limitations of the Balance Sheet?

According to financial accounting, a balance sheet gives information about the financial balances of business partnerships, sole proprietorships, other business organisations or corporations i.e. LLP or an LLC. At the end of a specific period such as at the end of the financial year, valuable information about assets, liabilities and owner's equity are incorporated in the balance sheet.

A balance sheet though provides very valuable financial information to investors and others but it has limitations due to the scope of timing being very narrow. It only provides information about the financial status of a company up to a specific date. In contrast, the investors or money lenders want to use the financial health of the company on the current date. 

For example, suppose according to the balance sheet a business is bearing cash in hand of $ 50,000 on 31 March 2022 and the investor or money lender wants to know the cash in hand of the company in August 2022 for a disbursing loans or investing money. 

Now in this case they (investor, and money lender) will not be in a position to know the liquidity position (cash in hand) on the date they want to invest or give a loan. Secondly, it will also not give an idea of how much cash in hand the company has to maintain to meet its day-to-day business requirements or petty expenses.

Moreover, some information incorporated in a balance sheet is not sure to be materialised as they are based on probability depending on the market condition, and changes in the financial conditions of the customers. 

For example, suppose a company has bills receivables worth $ 500,000 with 100 customers. Now the company can not ensure that its all money will be returned back or that how much amount will come later than the agreement terms. 

Therefore, though a balance sheet is the most important financial statement of a company, it still has some limitations like that of the narrowness of time and some transactions are based on forecasting the real materialisation of which can not be ensured and may not be useful for some investors, money lenders, banks, financial institutions and others.

What is Incorporated in Balance Sheet?

A balance sheet of the company incorporates all the financial information about the assets and liabilities of the company including shareholders' equity. It includes short and long-term assets such as cash in hand, inventory and bills receivables (short-term assets) and plant and machinery, equipment and property (long-term assets) whereas short-term liabilities which the balance sheet includes are wages payable, bills payables and long-term liabilities i.e. borrowings, bank loans, and other long-term obligations.

By Whom the Balance Sheet is Prepared?

The preparation of the balance sheet depends on the size and nature of the company. Generally, small size companies which are privately owned manage to prepare their accounts including balance sheets by the bookkeepers or by owners. Mid-size companies can prepare their balance sheet by hiring an accountant or outsourcing their preparation to external accountants.

In case of the public limited companies, the accounts and balance sheets are subject to audit by external auditors who submit their audit report to the company and that has to be open to the public. 

Therefore, public companies generally hire qualified accountants because they have to follow high standards accounting standards like IFRS or GAAP and must regularly submit to the Securities and Exchange Commission (SEC) so that these companies' accounts and activities can be ensured.

What is the Best Formula for Balance Sheet?

The calculation of the balance sheet is done by balancing assets with liabilities and equity of the company. The formula for calculating the balance sheet is:

total assets = total liabilities + total equity.

The total assets of the company include the sum of all the assets of the company i.e. short-term assets (BR, Inventory, Cash), long-term assets (Properties, Plant and Machinery) and other assets of the company whereas the liabilities include short-term liabilities (Bills Payable, Outstanding expenses) and long-term liabilities (Loans and Borrowings). 

The calculation of total equity is done by adding net income, stock of shares issued, retained earnings and owner's contribution.

Why Balance Sheet is Useful for Investors and Management?

The investors of the company like financial institutes, money lenders, the general public and others who are interested in investing their money in a company to get a safe and handsome returns analysis of the financial health and sustainability of the company before making any kind of investments.

The management and the owners of the company analyse the balance sheet to ensure the risk involved in the company, cash flow and cash in hand position at a specific time, short-term and long-term loans and borrowings and take vital decisions accordingly for ensuring the long-running of the company with maximum profits. 

Main Components of Balance Sheet

A balance sheet has two parts i.e. assets and liabilities. Each side includes different components and the balances of both the sides (parts) must tally to ensure its correctness.

Assets - it refers to what a company owes which is used for the efficient running of the business to earn profit. The basis of its classification is the physical existence, convertibility, and usage.

The components of the assets side of the balance sheet are:

1) Convertibility - This refers to the convertibility of an asset into cash. On this basis, the assets are divided as under:

a) Current Assets - Current assets include those assets which can be converted into cash easily. Some current assets are:

• Cash in Hand
• Bills Receivable
• Inventory
• Marketable Securities
• Pre-Paid Expenses

b) Fixed Assets - These are a kind of asset which can not effortlessly/easily transform/convert into cash. A few types of fixed assets are:

• Properties
• Plant and Machinery
• Trademark
• Goodwill
• Equipment

2. Physical Existence - These types of assets can be categorized into two parts i.e. tangible assets and intangible assets:

a) Tangible Assets - These represent the assets which are visible and can be felt. some elements of tangible assets are:

• Plant and Machinery
• Properties
• Equipment
• Office Supplies

b) Intangible Assets - These assets do not have physical existence and can not be seen. Some components of intangible assets are:

• Copyrights
• Brand
• Patents

3) Usage - The assets can be categorised into two parts:

a) Operating Assets - These include the assets which are unavoidable to the operations of a business viz:

• Plant and Machinery
• Building
• Equipment

b) Non-Operating Assets - These are the assets not necessary for the daily operations of a business viz:

• Marketable Securities
• Short-Term Investments

Liabilities

Liabilities mean that a business is in debt with different outside parties. The financial obligations and debts are included as liabilities arising out of the business activities. These liabilities are discharged by a company by paying cash or by delivering goods or services. On the right side of a balance sheet, the liabilities are shown.

The main components of liabilities are current liabilities and non-current liabilities.

1. Current Liabilities - The debts or obligations to be discharged within a year are called current liabilities or short-term liabilities. Some components of the current liabilities include the following:

• Interest Payable
• Bills Payables
• Short-Term Loans and Advances
• Wages Payable
• Dividends Payable

2. Non-Current Liabilities - These are the liabilities which have to be paid over the years i.e. not in the current year. These liabilities are also called long-term liabilities and include:

• Long-Term Loans and Advances Payable
• Bonds Payable
• Deferred Tax Obligations

Owners' Equity (Earnings)

Total assets minus total liabilities are equal to the owner's equity. This amount of owner's equity has to be paid to the shareholders after all the amount of debt has been paid and the liquidation of assets. Owners' equity is the best way to determine the net value of any business. 

The retained earnings include the shareholder's equity that has to be paid by way of dividends. This equity can either be positive or negative. If case the shareholder's equity is positive, it refers that the company has sufficient assets to discharge its liabilities whereas the negative equity refers to the shortage of funds over liabilities.

What are the Four Important Financial Performance Matrix of Balance Sheet?

1. Leverage - Leverage is the other method to mention debt. In business, it mentions borrowing funds to finance the buying of equipment, inventory or other types of assets. The companies make use of leverage in place of equity to buy these things.

2. Liquidity - In accounting terms, liquidity is a way by which a company pays its debts to the debtors on the date it becomes due. As mentioned above a balance sheet has three parts i.e. assets, liabilities and owner's equity. The prime part of assets shows the liquidity (cash) of the company in a specified period.

3. Rates of Return - Rate of return refers to the performance of the investments after a particular time and is conveyed as a percentage of its original cost. The returns of investment can be either positive or negative. A positive return means the profit or gain in investments whereas a negative return refers to the loss on investments. 

4. Efficiency - It refers to the efficiency of the company to use its resources like assets, equity, and borrowings to attain maximum gains or profits. It refers to that how efficiently a company does its total expenses to generate income.

Interpretation of Balance Sheet with Cash Flow and Income Statements

The cash flow statement and a balance sheet are two core financial statements out of the three. The cash flow statement gives the data about the cash performance of the company which is used by the investors in making their investment decisions. This statement is also used by creditors and market analysts to keep watch on the financial health of the company.

The income statement gives a picture of the profit and loss of the company for a specific period whereas by analysis of the balance sheet the financial health of a company can be known. Therefore, all three statements a balance sheet, cash flow and income statements play an important role in collecting valuable information about the financial health, flow of cash and profit and loss of the company at a specific period.

How to Read Balance Sheet?

The balance sheet is one of the three core financial statements which gives a true and fair picture of the financial health of the company. It helps investors and others to analyze the financial position of the company at a particular time. 

It allows investors and creditors of the company to know the financial position and flow of cash so that they can assess their money is in safe hands and that the company is capable of repaying short-term and long-term loans and borrowings.

The balance sheet is divided into two parts i.e. assets and liabilities of the company which are subdivided into different subheads like loans are divided as short-term loans and long-term loans, assets are divided as tangible and intangible assets, fixed and floating assets and so on. So it becomes for any reader of a balance sheet to understand the position of the company in different heads and sub-heads.

To Sum Up

A balance sheet is the most important part of accounting. It is very useful for management. creditors and investors to know the financial health of an organisation. This is one of the most critical three financial statements i.e. cash flow statement income statement and balance sheet.

A balance sheet gives the true and fair picture of the financial health of the company at a specific point in time. The balance sheet is based on actual data and therefore is not a source of future forecasting. For any financial forecasting, the company has to analyse the previous period data incorporated in those balance sheets.

There are a large number of benefits of a balance sheet regardless of the size or nature of any company. A balance sheet incorporates all the facts and figures about the company's debts and what it owns. It helps investors in risk determination.

Frequently Asked Questions (FAQ)

1. What are the 3 Types of Balance Sheets?

• Comparative balance sheets
• Horizontal balance sheets
• Vertical balance sheets

2. What are the Balance Sheets Example Items?

Assets like inventory, cash, investments, bills receivables, prepaid expenses and fixed assets.

Liabilities like short-term debts, long-term debts, allowances for doubtful accounts, bills payable, accused and tax liabilities payable.

3. What is the definition of Balance Sheets Items?

The balance sheet items are the items which refer to the assets and liabilities and shareholder's equity on a specific date.

4. What is a Balance Sheet List and Define the three Components of the Balance sheet formula?

The three components of a balance sheet are assets, liabilities and equity (net worth). The balances of assets and liabilities can not be tallied unless equity is added in the liabilities. So the formula of a balance sheet is:

Total Assets - Total Liabilities + Total Equity.

5. What are the five key Components of the Balance Sheet?

• Assets - Current and Non-Current Assets.
• Liabilities - Current and Non-Current Liabilities (short-term liabilities and long-term liabilities).
• Shareholders Capital 

6. What are the 4 Components of the Financial Statements?

In case a business looking for an investor or applying for the loan, the following 4 financial statements are required to be submitted:

• Income Statement
• Fund Flow Statment
• Balance Sheet
• Statement of owner's equity 

These 4 financial statements will help the company for speedy investments or loans.

7. What are the 4 sections of a Balance Sheet?

There are four most important sections in which a balance sheet is divided are:

• Headings
• Assets
• Liabilities
• Owner's Equity 

8. What is Assets Formula?

9. What are the 5 Types of Accounts?

10. What is the Formula of Equity?