What a balance sheet is for, why it's important and what you should know.
What is a Balance Sheet?
A balance sheet is a financial statement that provides a snapshot of what a business owns and owes, as well as the amount invested by shareholders.
It provides a basis for computing rates of return and evaluating the company's capital structure. Along with other important financial statements such as the statement of cash flows in the income statement, a balance sheet is used in conducting fundamental analysis or calculating financial ratios.
A balance sheet’s formula, or equation, is simple and intuitive: assets equal liabilities plus equity. In other words, a business must pay for the things it owns (assets) through either taking on liability (borrowing) or issuing shares to investors.
Why is the Balance Sheet Important?
In essence, a balance sheet is a snapshot of the company’s financial standing at a given moment in time. Taken alone, it does not give a sense of trends that will play out over a longer timeframe. That’s why balance sheets are compared with ones from previous time periods and with balance sheets of other businesses in the same industry. Investors can get a sense of a company’s health by looking at, among others, the debt-to-equity ratio, and the acid-test ratio.
There are limitations to a balance sheet. Although it’s a good reflection of the assets and liabilities a company owns, it is static and only applicable to a certain time period. That’s why it’s important to draw on data in the income statement and statement of cash flows to paint a fuller picture of the company’s standing.
Tip: Prep your balance sheet during the same period each year. This ensures you have a good baseline comparison year to year.