A balance sheet is an essential tool for investors and businesses alike. It is also known as a sheet of financial position because it contains a business’s financial position. It contains everything required to evaluate a company’s financial position.
It contains every bit of information about the assets that the company owns, all the liabilities of the company, what kind of shareholder’s equity there is, and everything required to evaluate a company’s financial position, whether it holds a strong financial position or is it in a very weak financial position.
The main reason a business prepares a balance sheet is that it must disclose its financial position according to the regulatory authorities and laws.
While the balance sheet can be made at any time to provide up-to-date financial information, the usual practice is to prepare it at the end of the accounting period, specified by the company or the regulatory authorities, which is usually at the end of each quarter.
How is a balance sheet divided?
A balance sheet is divided into three main parts, which may be further divided into multiple parts depending on how detailed the balance sheet report is.
Figure 1 below provides all the details about the division of a balance sheet.
Figure 1: The balance sheet division
According to figure 1, the balance sheet is divided into three main parts: Assets, liabilities, and shareholders’ equity. All three parts of a balance sheet are explained in great detail below:
An asset can be said to be a resource owned by a business. There exist multiple asset classes with their own sub-classes. Some examples of assets that a business can own are equipment, land, bonds, intellectual property, and contracts.
The more assets a company owns, the healthier its balance sheet appears. The healthier the balance sheet is, the better the financial condition a company is in.
The companies would like to own more assets to appear more attractive to investors. Furthermore, owning more assets can result in that company surviving economic downturns.
All the assets are not equal, and some assets are hard to put a value on, like intellectual property. While assets in balance sheets can be divided into multiple types, the most common practice is to divide the assets into current and non-current assets.
The current assets are those which can be quickly monetized, and non-current assets are those which cannot be quickly monetized.
Liabilities are obligations of a business. These can be loan payments, contractual obligations, bonds, and rent.
Just like assets, liabilities are also divided into current and non-current liabilities. The balance sheet can divide the liabilities further, but it is not a usual practice.
Current liabilities are those obligations due within a year, whereas non-current liabilities are those due after more than a year.
The fewer liabilities the business has on its balance sheet, the better it is for that business because it is a much healthier business.
The shareholder’s equity is the amount of ownership of the owner in a business. For businesses that have a single ownership structure or their ownership structure is not a limited liabilities company or LLC, the shareholder’s equity is referred to as owner’s equity.
Equity means ownership. How much does a business or shareholders own a business? The shareholder’s equity is the last part of a balance sheet. It comes after the liabilities section.
Types of formats of a balance sheet
The types of formats of a balance sheet are given in figure 2 below:
The four main types of balance sheet formats given in figure 1 are the classified balance sheet, vertical balance sheet, comparative balance sheet, and common-size balance sheet.
Each has its advantages and disadvantages. The details of both types of format sheets are given below:
Classified Balance Sheet Format
Classified sheet format is one of the most widely used formats in the reporting of financial conditions of a company in the form of assets, liabilities, and shareholder’s equity. It helps to consolidate all accounts into one comprehensible format.
Vertical Balance Sheet Format
The balance sheet report provides all the details about the assets, liabilities, and equity in a single vertical line.
The assets are reported at the top, the liabilities are reported, and the shareholder’s equity is reported.
One of the disadvantages of the report balance sheet format is that it makes it much harder to compare assets and liabilities.
Because, unlike the Classical Balance sheet format, the assets and liabilities are not in front of each other in the balance sheet.
Comparative Balance Sheet Format
The comparative balance sheet format compares different parts of a balance sheet. This format provides side-by-side information regarding a company’s assets, liabilities, and shareholders’ equity, making it very easy to compare different components of a company’s balance sheet.
Common size balance Sheet Format
The common-size balance sheet format is the same as the classified balance sheet. Still, it does have one major difference, and that is that it also provides a separate column that provides percentage point information regarding assets, liabilities, and equity.
The common-size balance sheet format is useful for comparing trend lines.
Importance of Balance sheet
Balance sheets are very important financial tools. The reasons balance sheets are so important are given as follows:
- They provide details about the financial position of the company.
- It helps in evaluating the financial health of the company.
- The information provided in the balance sheet is a great tool for creditors to help evaluate how big a loan the company can take on which it can pay back.
- The balance sheet help evaluate the future performance of the company based on the current financial position.
The balance sheet is a super important tool for every business, no matter how big or small. The business must know which format best suits its need, whether it’s a T-form or report form balance sheet.