Definition of the Term Balance Sheet

All businesses, from giant multinationals to small firms, should periodically evaluate and present their financial status (this is legally required of publicly traded corporations). The balance sheet pays a key role in this accounting by providing a "snapshot" of the company's overall condition. For investors the balance sheet is one of the most important sources of information about a company.

Identification

The term "balance sheet" refers to a summary of a business's financial condition. It is composed of an itemized listing of assets, a similar listing of liabilities and a statement of shareholders' equity. Total assets must equal total liabilities plus equity. Additional information is often included to explain or supplement the balance sheet.

Time Frame

A formal balance sheet is drawn up and presented by most companies to investors once a year. This is a required document for publicly traded firms and is included in their annual report. The balance sheet should be reviewed by an independent auditor to ensure completeness and accuracy. Partial or interim balance sheets are common as well. Management uses them to provide information during a company's fiscal year or to analyze specific operations or issues.

Structure

The first section of any balance sheet examines assets. Total assets are listed at the end after amounts for specific categories such as fixed assets (real estate and equipment, for example), cash, accounts receivable and inventory. Under the second section, liabilities, the same pattern is followed, with categories for accounts payable, bonds and short-term debt. The final part of the balance sheet is equity (or stockholders' equity). For a balance sheet to be valid, liabilities plus equity must always be equal to assets. Two more features are common to good balance sheets, though not required. One is a section of explanatory notes to address investor concerns and/or clarify specific items. This is added to the end of the balance sheet. The other feature is the previous year's balance sheet listed parallel to the current version, which helps investors and management to see at a glance what changes have occurred in the previous 12 months.

Uses

Investors pay careful attention to entries on a balance sheet, particularly in the liabilities section. For example, investors prefer to see a company that has limited debt compared to assets. Even a company that is doing well can run into trouble if it's overextended and unexpectedly faces a business downturn. The same is true if there is an excess of short-term debt, which typically requires more cash to service than long-term debt---a potential problem if the firm should find itself short of cash.

Context

Although the balance sheet itself contains useful information, its real value becomes apparent when managers and investors place the information in the context of other figures such as annual revenue, earnings and market share. For example, suppose a company's inventory has risen sharply (found under assets). That might be a signal the company's products aren't selling well. But before jumping to conclusions, a savvy investor will look at recent revenues. If there are corresponding increases in sales to the growth in inventory, there's no cause for concern. The company has run up inventories not because of poor sales but to keep up with growth. There are many other items of useful information you can get from balance sheet analysis as well. Check the links below for more information.