Balance Sheet Law and Legal Definition
A balance sheet is an accounting tool used to summarize the financial status of a business or other entity. It generally lists assets on one side and liabilities on the other, and both sides are always in balance. Assets and liabilities are divided into short- and long-term obligations including cash accounts such as checking, money market, or government securities. At any given time, assets must equal liabilities plus owners’ equity. An asset is anything the business owns that has monetary value. Liabilities are the claims of creditors against the assets of the business. A balance sheet is usually prepared each month, quarter of a year, annually, or upon sale of the business, in order to show the overall condition of the company.
A balance sheet is a financial report that provides a snapshot of a business's position at a given point in time, including its assets (economic resources), its liabilities (debts or obligations), and its total or net worth (assets less liabilities). "A balance sheet does not aim to depict ongoing company activities," wrote Joseph Peter Simini in Balance Sheet Basics for Nonfinancial Managers. "It is not a movie but a freeze-frame. Its purpose is to depict the dollar value of various components of a business at a moment in time." Balance sheets are also sometimes referred to as statements of financial position or statements of financial condition.
Balance sheets are typically presented in two different forms. In the report form, asset accounts are listed first, with the liability and owners' equity accounts listed in sequential order directly below the assets. In the account form, the balance sheet is organized in a horizontal manner, with the asset accounts listed on the left side and the liabilities and owners' equity accounts listed on the right side. The term "balance sheet" originates from this latter form: when the left and right sides have been completed, they should sum to the same dollar amounts—in other words, they should balance.
CONTENTS OF THE BALANCE SHEET
Most of the contents of a business's balance sheet are classified under one of three categories: assets, liabilities, and owner equity. Some balance sheets also include a "notes" section that holds relevant information that does not fit under any of the above accounting categories. Information that might be included in the notes section would include mentions of pending lawsuits that might impact future liabilities or changes in the business's accounting practices.
Assets are items owned by the business, whether fully paid for or not. These items can range from cash—the most liquid of all assets—to inventories, equipment, patents, and deposits held by other businesses. Assets are further categorized into the following classifications: current assets, fixed assets, and miscellaneous or other assets. How assets are divided into these categories, and how they match corresponding liability categories, are important indicators of a company's health.
Current assets include cash, government securities, marketable securities, notes receivable, accounts receivable, inventories, prepaid expenses, and any other item that could be converted to cash in the normal course of business within one year.
Current assets should reasonably balance current liabilities. Current assets divided by current liabilities produce one of the "health indicators" of a company, the "Current Ratio." If that ratio is unfavorable, the company may lack liquidity—meaning the necessary resources to meet its cash obligations. Since inventories are sometimes difficult to turn into cash, the "Acid Test" is another ratio used. It includes Current Assets less Inventory divided by Current Liabilities. The company's "Working Capital" is determined by deducting Current Liabilities from Current Assets. Rather than being a ratio, it is a dollar-denominated indicator of a company's health.
Fixed assets include real estate, physical plant, leasehold improvements, equipment (from office equipment to heavy operating machinery), vehicles, fixtures, and other assets that can reasonably be assumed to have a life expectancy of several years. In practice most fixed assets—excluding land—will lose value over time in a process called depreciation. Fixed assets are reported net of depreciation in an attempt to claim only their current value.
Fixed assets also include intangibles like the value of trademarks, copyrights, and a difficult category known as "good will." When someone buys a company and pays more for it than the worth of current and fixed assets combined, the difference is written into the books of the acquired entity as "good will." The value of this good will cannot be extracted again unless by sale to another willing buyer.
Fixed assets, of course, should be in some reasonable balance with long-term liabilities. If a company owes more for capital purchases than those purchases are worth on its books, that is an indicator of potential problems.
Liabilities are the business's obligations to other entities as a result of past transactions. These entities range from employees (who have provided work in exchange for salary) to investors (who have provided loans in exchange for the value of that loan plus interest) to other companies (who have supplied goods or services in exchange for agreed-upon compensation). Liabilities are typically divided into two categories: short-term or current liabilities and long-term liabilities.
Current Liabilities are due to be paid within a year. These include payments to vendors, payable taxes, notes due, and accrued expenses (wages, salaries, withholding taxes, and FICA taxes). Current liabilities also include the "current" portion of long-term debt payable during the coming year. Long-term liabilities are debts to lenders, mortgage holders, and other creditors payable over a longer span of time.
Once a business has determined its assets and liabilities, it can then determine owners' equity, the book value of the business: the remainder after liabilities are deducted from assets. Owners' equity, also called stockholders' equity if stockholders are involved in the business, is in essence the company's net worth.
A company's "leverage" is calculated using its total equity. "Leverage" is long-term debt divided by total equity. The higher the leverage, the more a company is financed by borrowing. People then say that it is "highly leveraged," i.e., it is more vulnerable to market shifts which make it difficult for it to service its debt. If leverage is small or modest, the company is able to control its own destiny with greater certainty.
BALANCE SHEETS AND SMALL BUSINESSES
As shown above, the balance sheet, if studied closely, can tell the small business owner much about the enterprise's health. In Balance Sheet for Nonfinancial Managers, for instance, Simini points out that "in a well-run company current assets should be approximately double current liabilities." He goes on: "By analyzing a succession of balance sheets and income statements, managers and owners can spot both problems and opportunities. Could the company make more profitable use of its assets? Does inventory turnover indicate the most efficient possible use of inventory in sales? How does the company's administrative expense compare to that of its competition? For the experienced and well-informed reader, then, the balance sheet can be an immensely useful aid in an analysis of the company's overall financial picture."
The small business owner, by mastering the concepts hidden in the balance sheet, can also effectively foresee what a bank or other lender will see when looking at the company's balance sheet—and what to do in anticipation to make the numbers look better by changes in purchasing, collections, prepayments, and by other management actions within the owner's competence.
SEE ALSO Annual Report
"Analyzing Company Reports." Ameritrade, Inc. Available from www.ameritrade.com/educationv2/fhtml/learning/balsheetanalysis.fhtml. Updated in 2003 to reflect changes in the Internal Revenue Code enacted by Congress.
Atrill, Peter. Accounting and Finance for Nonspecialists. Prentice Hall, 1997.
Bangs, David H., Jr., and Robert Gruber. Finance: Mastering Your Small Business. Upstart, 1996.
Simini, Joseph Peter. Balance Sheet Basics for Nonfinancial Managers. Wiley, 1990.
Hillstrom, Northern Lights
updated by Magee, ECDI