What is a balance sheet?
A balance sheet is a document that summarises a company’s finances. It will include its assets, liabilities and shareholder equity.
Investors will use a balance sheet to get a picture of a company’s finances. In turn, that information can be used to guide investment decisions.
A healthy balance sheet might be a positive sign for investors and lead them to put money into a company. Conversely, a balance sheet that shows a business has bad finances could mean investors want to sell their shares in that firm or not invest in it at all.
Understanding a balance sheet
Balance sheets aren’t tricky to understand but you do need to know a few financial concepts in order to do so. Those are assets, liabilities and shareholder equity.
What are assets?
Assets are things that companies own. A company might have cash holdings and own real estate and stocks. All of these things would be considered assets.
When you look at a balance sheet, you’ll often see a company’s assets ordered according to their liquidity. In a financial context, liquidity refers to how easily an asset can be exchanged for cash.
Knowing how liquid a company’s assets are is important because it will need to pay its liabilities with cash. So if a company has to pay off a lot of liabilities in the short-term, it will need assets that it can easily convert into money.
Because of this, balance sheets will often divide assets into two categories — current assets and non-current assets.
Current assets are things that you can expect to be converted into cash in under a year, like cash or stocks.
Non-current assets are things that are more likely to take over a year to be converted into cash, like large real estate holdings or machinery.
What are liabilities?
Liabilities are all the things that a company has to pay for. Borrowed money, staff wages and rent are all examples of liabilities.
Like assets, liabilities are often arranged into two categories — current liabilities and long-term liabilities.
As the name suggests, current liabilities are shorter-term cash payments that a company will have to make. It might include salaries or an upcoming payment on a loan.
Long-term liabilities are the opposite. They’re payments that a company will have to make in over a year’s time. That could also include payments on a loan or a tax payment.
What is shareholder equity?
Shareholder equity is the cash value that remains when you subtract a company’s liabilities from its assets.
Shareholder equity matters because it is a good indication as to how strong a company’s finances are.
If a company has negative shareholder equity, it means it does not have the assets to meet its liabilities. Such a company could risk going insolvent and leave its shareholders with nothing.
How are balance sheets useful for investors?
Balance sheets provide a snapshot into a company’s finances and can give investors an approximate idea of how a business is performing. That can help them make better investment decisions.
Still, like most pieces of financial information, the balance sheet should be looked at in conjunction with other data because it only captures part of a company’s story. Moreover, companies have been known to play with the data they put into their balance sheets to make them look more favourable — so look out!