Balance Sheet: what is it and how to analyze
What is balance sheet
The balance sheet is a financial report that aims to detail the net worth of a company, that is, to show everything that the company owns (assets) and owes (liabilities).
A company's equity is nothing more than the difference between assets and liabilities.
Net worth = Assets - Liabilities
Therefore, assets it is also equivalent to net worth plus liabilities. This equation explains the name given to this report: "balance sheet".
Assets = Net worth + Liabilities
Difference between balance sheet and income statement
Unlike the income statement, which shows the result obtained in a period of time, the balance sheet reflects the situation of the company at a given moment.
Among the 3 financial reports (income statement, balance sheet and cash flow), the most recurrent and perhaps the easiest to understand is the income statement.
This may give the impression that the balance sheet is less relevant when analyzing a company's financial health, but the reality is that more experienced analysts and managers often prefer to check the balance sheet first before analyzing the results of the period.
One of the reasons for this is that the balance sheet is largely a reflection of the sequence of results obtained, so if the company had excellent results in previous periods, there are good chances that assets are greater than liabilities.
We will detail the lines that make up the assets and liabilities, but this post aims to bring the main information to help in the general understanding of a balance sheet for entrepreneurs only.
What is the structure of the balance sheet
The equity is calculated based on two groups: assets and liabilities. Let's detail what makes up each of these groups.
An asset is anything the organization owns, such as cash and stock, accounts receivable, inventory, land, buildings, equipment, prepaid assets, patents, and other intangible assets.
As you can see, there are many different types of assets and we'll talk in a little more detail about each one, but before that, let's talk about how they're grouped together on the balance sheet.
Assets are classified as current or non-current. These terms serve to differentiate assets that have high and low liquidity. In case you are not familiar with the term, liquidity is the ability to convert an asset into cash.
Current assets: are those with high liquidity and can be converted into cash in up to 1 year.
Non-current assets: are all other assets that take more than 1 year to be converted into cash.
In addition to being in one of these two groups, assets are usually ordered in descending order of liquidity.
Now let's detail each of the lines we commented on. The names or breakdown of the items below may vary according to the company, but serve as a basis on the main components of the assets.
1. Cash and Cash Equivalents
Basically the money that the company has in the bank and the sum of the value of the shares that it owns. Contrary to some lines that we will see below, the value of this group does not suffer much variation based on assumptions applied by the accountants.
2. Accounts Receivable
It is the value that customers owe the company. Therefore, it tends to be higher as the installment payment for products grows. This is considered an asset because it is an amount expected to enter cash at some point.
Based on history, it is possible that the organization records a provision for customers who are unlikely to complete payment, reducing the amount recorded in accounts receivable.
It is formed by the value of finished products, products in production and the value of raw materials in stock at the time of consolidation of the balance sheet.
There are different ways to calculate each of these types, which can sometimes yield significantly different results.
4. Property, Plant and Equipament
This includes land, buildings, machines, trucks, computers and other physical assets of the organization. The value considered in the balance sheet is equivalent to the purchase price of each of these assets.
From an analysis point of view, this is good to avoid variations due to more "subjective" aspects of the value of each of these assets, but, in some cases, it may not be something so positive for the organization.
If a land was purchased for $ 1 million and, after 5 years, it became worth $ 3 million, in the balance sheet it will be considered as $ 1 million, for example.
These assets, with the exception of land, are depreciated over time, however the depreciation is seen on the income statement and not on the balance sheet.
A point of attention is that depreciation can be measured in different ways, which can significantly change the organization's results. For example, if equipment is initially depreciated over a period of 3 years and then started to be depreciated over 4 years, the impact on profit can be very different.
Obviously, there are accounting rules that guide the appropriate time to be considered and good practices to avoid changing these criteria frequently. Anyway, it's worth keeping an eye out.
Goodwill appears on balance sheets of companies that acquired other organizations. It refers to the value of intangible assets arising from acquisitions, such as the brand, list of clients and professionals, for example.
6. Intellectual property, Patents and Other intengibles
Intangible assets, such as patents, can generate revenue for years, so they are not expenses allocated directly to the Income Statement, considering that the Income Statement only records expenses related to the revenue generated in the period.
Therefore, intangibles must be included in the balance sheet and amortized over time. As with depreciation for tangible assets, there are different rules or ways to amortize intangible assets, however, as they tend to be amortized over many years, they tend to have less of an impact on the Income Statement.
7. Accruals and Prepaid Assets
Prepaid assets are advance purchases made by the company, but which are expected to bring financial returns over time.
Imagine a company that rents a space for $ 120,000 per year, but the company that rents the space wants the payment to be made in advance.
Recording this expenditure of $ 120,000 in the Income Statement at once does not make sense, considering that it will bring returns throughout the year.
As the amount has already been paid in advance, the space is considered a company asset, so only $ 10,000 will be spent on the Income Statement each month, while the remaining amount will be allocated as an asset on the balance sheet.
Liabilities are all that the company owes. Like assets, it is divided into current and non-current.
Current liabilities: are those that must be paid within 1 year
Non-current liabilities: have a payment period of more than 1 year.
Generally, the item with the shortest payment term is the first listed and the longest term the last.
As with assets, the names or breakdown of the items below may vary by company, but serve as a basis on the main components of liabilities.
1. Short-term Loans
Loans made that need to be paid up to 1 year. They are usually secured by the organization's current assets.
Installments of long-term debt that must be paid within 1 year may be included. Imagine a company that decided to take out a loan of $ 50,000 to be paid in up to 2 years. Assuming that $ 25,000 needs to be paid within 1 year, and the other $ 25,000 just next year. Half of the loan will be allocated to current liabilities and the other to non-current liabilities.
2. Accounts Payable
It is possible that delivery from suppliers is not fully paid upon receipt, sometimes it is agreed that payment is made on a specific date. This amount that still needs to be paid at the time the balance sheet is consolidated is recorded in liabilities within the accounts payable line.
Recording the salary of an employee who will only be paid on July 1st in the June Income Statement does not make much sense. Therefore, wages that will be paid in the following month are included in the balance sheet, but referring to the month of the measured result.
4. Long-term Liabilities
Loans made that can be repaid over a period of more than 1 year.
This publication was based on the book Financial Intelligence for Entrepreneurs. It's an excellent book for anyone who wants to understand the main components of key financial reports (Income Statement, Balance Sheet, and Cash Flow) and know how to analyze them.
The book brings several examples of how different assumptions can be considered in the preparation of reports and how this can allow significantly different results to be obtained.