Definition, Components and Examples of a Balance Sheet
Table of Contents
1. What is a Balance Sheet?
The balance sheet is a snapshot of a company’s assets, liabilities and equity at a specific date. In other words, it shows how much a company owns and owes.
The balance sheet is one of the three major financial statements next to the income statement and the cash flow statement. It is sometimes also referred to as the statement of financial positions or the statement of net worth.
While the income statement and the cash flow statement report for a period of time (e.g. 1 January until 31 December), the balance sheet always captures the financials at the close of business of a single date (e.g. 31 December).
The balance sheet follows an important principle: The assets of a company must always equal the liabilities plus the equity.
As a rule of thumb:
The assets of a balance sheet show where the company’s money is invested in (cars, machines), while the liabilities and equity show where the money comes from (shareholders vs. debt).
2. Assets on a Balance Sheet
2.1. Definition of an Asset
An asset represents a resource controlled by a company or individual that allows generating future economic benefits, in particular cash flow. In simple words: An asset is something that is owned by or has a value to a company or individual.
According to the International Accounting Standards Board (“IASB”), the following characteristics define an asset:
- The item must provide a benefit that allows it to generate future cash flows
- The company that owns the item must be able to restrict other entities’ access to that benefit
- The rights to the benefit legally lie with the entity
Let’s look at a machine as an example of an asset on the balance sheet. Once the company bought the machine, it has the ownership right to it. Therefore, it can restrict other entities’ access to that machine and use it to produce products that generate cash flow for the company.
Assets can generally be classified into
- current assets,
- non-current assets and
- other assets.
Let’s have a more detailed look at them.
2.2. Current Assets on a Balance Sheet
A current asset is an item that fulfills the requirements of being an asset, while its useful life is estimated not to exceed 12 months.
The following general examples classify as current assets:
- Cash or cash equivalents, which are not limited in their useful lives
- Items held for trading purposes
- Items that get consumed, sold or expire within 12 months
In our prior example, the machine would not fall under current assets but long-term assets. The exception to this would be a company that is trading with machines as their daily operations. In that case, they would classify as “items held for trading purposes” and hence represent a current asset.
Another example of current assets is inventory. A company buys goods and materials in order to manufacture products. That implies that the inventory – under normal circumstances – is consumed within the normal operating cycle and should hence be classified as current.
Let’s look at some current asset lines on the balance sheet to get a better feeling of its content.
Cash and Cash Equivalents
Cash describes a currency that is available on the bank accounts of a company. Cash equivalents are all current assets that can quickly be transferred into cash, such as money market funds, short-term bonds and commercial paper.
An accounts receivable position increases when a customer chooses to purchase a product or service on credit, as opposed to cash. It reduces again once the customer pays.
The balance sheet position inventory contains all raw materials and goods that are ready for sale or consumption. When a company purchases oranges to produce orange juice, the oranges are inventory to the company. Once the company produces the juice and sells it to customers, the inventory position will decrease by the value of the oranges consumed.
A prepaid expense is a current asset for the payment of a cost before it is invoiced. Let’s assume that the company was so happy with the oranges of this season that it already ordered and paid oranges for the upcoming season. The pre-purchase would decrease the cash position on the balance sheet, while prepaid expenses would increase by the same amount. Effectively, there would be no net change on the balance sheet as one asset declines while the other increases.
2.3. Non-Current Asset on a Balance Sheet
An asset classifies as non-current if it has long-term use to the company, i.e. more than 12 months. These assets can be tangible and intangible as well as operating or financial assets:
- Long-term financial investments
- Property, plant & equipment
- Brands, patents, goodwill
Let’s have a look at some non-current assets on the balance sheet.
Long-term investments can be stocks, bonds, as well as minority shareholdings of other companies.
Property, Plant & Equipment
PP&E are a category of fixed assets that support the company’s operations. In our previous example, this would be the machine that squeezes the oranges, as well as the building in which the operations take place.
Intangible assets comprise things that cannot be physically touched, yet, still exist and have a value to the company. Brands, patents, trademarks as well as goodwill represent such examples.
2.4. Other Assets
Other assets include all additional items that don’t fit the current and non-current asset requirements. These can be e.g. long-term deferred assets that a company does not plan to use up within a normal operating cycle of the company.
3. Liabilities on a Balance Sheet
3.1. Definition of a Liability
- A liability is an obligation that results in the transfer of an economic benefit to another company or individual. In plain words: A liability is any debt or financial obligation.
- Liabilities are the residual value when subtracting shareholders’ equity from the total assets
- Like assets, liabilities can be classified as current and non-current
The IASB lists the following characteristics for a liability:
- A liability obliges to transfer an economic resource (e.g. cash), either on-demand, when a specific event occurs or at a pre-set date.
- The obligation to the transfer is compulsory and cannot be avoided
- There must be a legal basis to that obligation (e.g. contract signing) created in the past
The following events, amongst others, create a liability:
3.2. Current Liabilities of a Balance Sheet
Similar to current assets, current liabilities have a life of no more than 12 months. In particular, the following requirements must be fulfilled for items to be classified as current liabilities:
- The settlement of the obligation takes place within a normal operating cycle
- The obligation must be settled within 12 months from the preparation of the balance sheet and cannot be deferred beyond that period
- It is held for trading purposes
The following gives an overview of the main current debt items:
Accounts payable is a short-term debt or obligation that is owed to a supplier of the company. If the company of our earlier example buys its oranges on credit as opposed to cash, accounts payable on the balance sheet increases.
Accrued liabilities is the balance sheet position of expenses that have been incurred but where the invoice has not yet been received. Most of the time, the accrued liability position is only an estimate of the costs, and the actual value will likely differ. An example would be a utility bill (gas, water, electricity). The company incurs cost over a period of time, but the actual invoice will only be received at the end of the utility period. Once the company receives the invoice, the accrued liability position will turn into accounts payable until payment occurs.
Short term debt refers to the portion of the debt that comes due within twelve months. For example, this could be a revolving credit facility used for funding short-term working capital needs. Moreover, it can also be maturing long-term debt, which is then labeled as “current portion of long-term debt”.
3.3. Non-Current Liabilities on a Balance Sheet
If a company does not need to settle an obligation within the current operating cycle, it must classify the liability as non-current. These mainly include
- long-term capital structure obligations,
- financial obligations, as well as
- contingent liabilities, where the obligation or magnitude is still uncertain.
Let’s look at a few examples.
Non-current borrowing includes all items that concern the long-term capital structure of the company. For example, these include long-term loans and bonds issued that require repayment at some point in excess of 12 months.
A deferred tax liability exists due to the difference between tax and accounting methods. The classification as non-current requires the deferred tax liability to have a due date beyond 12 months.
Finance Lease Liabilities
If a company decides to lease a machine instead of buying it, the company has to activate the sum of the future lease payments on their balance sheet.
Retirement obligations can include, for example, pension obligations to employees. These are entitlements of employees, depending on their years of service, that the company pays out once the employee retires.
4. Shareholders’ Equity on a Balance Sheet
4.1. Definition of Equity
- Shareholder equity is the interest of the owners after subtracting the total liabilities from the total assets.
- Equity = Assets – Liabilities
- It represents the sum of the cumulative net results of all past transactions and events that affected the company since its foundation
4.2. Share Capital
The share capital of the balance sheet is the cash that a company received through selling ordinary and preferred stocks.
As an example: A company issued 50 ordinary and 50 preferred shares at a nominal/par value of €1 but was able to sell all shares at €10. The balance sheet would list a share capital from ordinary and preferred stocks of €50 each (at the nominal value). The additional cash that the company generated on top of the nominal value is listed under “additional paid-in capital”, which would amount to €900 in the example. Therefore, the total share capital equals €1000.
4.3. Retained Earnings
Retained earnings record the balance of all accumulated net earnings since the foundation of the business. In other words: The net income that a company generates every year – at least the part that is not distributed to the shareholders – will accumulate under “retained earnings” on the balance sheet.
If a company generates a positive net income, retained earnings and hence shareholders’ equity will increase (if not distributed). Vice versa, if the company incurs a net loss, retained earnings decrease.
Some jurisdictions additionally oblige companies to put aside a small part of their income instead of distributing the total net earnings to shareholders. However, this would be disclosed on a separate line item on the balance sheet.
5. Balance Sheet Example and Excel Template
6. Balance Sheet – IFRS vs. US GAAP
Under the US General Accepted Accounting Principles (“GAAP”), the assets are usually arranged in the order from most to least liquid, so starting with current assets, followed by non-current assets. Under IFRS, most balance sheets arrange their assets in the opposite order. So, starting from the least to the most liquid and non-current to current.
Further, the liabilities and shareholder’s equity are ordered differently. GAAP lists them by increasing due date, so starting with the short-term debt, then long-term debt, followed by the equity. IFRS usually takes the opposite way by listing them by decreasing due date.