This statement reveals your company's relative wealth or financial position at a given point in time. It's often referred to as a snapshot because it gives you a fairly clear picture of the business at that moment, but does not in itself reveal how the business arrived there or where it's going next. That's one reason why the balance sheet is not the whole story—you must also look at the information from each of the other financial statements (and at historical information as well) to get the most benefit from the data.
Along with other financial information, balance sheet data is frequently analyzed and put into perspective through the construction of business and financial ratios. In many cases, ratios are constructed for each balance sheet (and income statement) for a number of years, so that you can make comparisons and spot important trends.
The balance sheet consists of three categories of items:
- stockholders' or owners' equity
Assets are generally divided into two groups: current assets and fixed (long-term) assets. They are usually presented in order of liquidity, with current assets (cash and those that will be converted to cash within one year) appearing first.
|Short-term investments and marketable securities||$ X|
|Accounts and notes receivable||$ X|
|Prepaid expenses||$ X|
|Other current assets||$ X|
|Total current assets||$ X|
|Machinery and equipment||$ X|
|Capitalized leases||$ X|
|(Less accumulated depreciation and amortization)||$ X|
|Deferred charges||$ X|
|Other fixed assets||$ X|
|Total fixed assets||$ X|
Liabilities are normally presented in order of their claim on the company's assets (i.e., liabilities due within one year are presented before liabilities due several years from now).
|Accounts payable||$ X|
|Notes payable||$ X|
|Income taxes currently payable||$ X|
|Current portion of long-term debt||$ X|
|Other current liabilities||$ X|
|Total current liabilities||$ X|
|Long-term debt||$ X|
|Capital lease obligations||$ X|
|Deferred income taxes||$ X|
|Other long-term liabilities||$ X|
|Total long-term liabilities||$ X|
Stockholders' equity (or owner's equity or net worth) is presented properly when each class of ownership is presented with all its relevant information (for example, number of shares authorized, shares issued, shares outstanding, and par value). If retained earnings are restricted or appropriated, this also should be shown.
Stockholders' equity for an incorporated business normally would take this form:
|Preferred stock, $20 par value (authorized 1,000 shares; issued and outstanding 500 shares)||$ X|
|Common stock, $15 par value (authorized 10,000 shares; issued and outstanding 5,000 shares)||$ X|
|Additional paid-in capital, common stock||$ X|
|Retained earnings||$ X|
Using Balance Sheet Data
You don't have to be an accountant to make effective use of the data on your balance sheet. Use balance sheet data to monitor your company's financial health by monitoring the following:
- Working capital: maintain a proper ratio of current assets to fixed assets.
- Cash levels: maintain only as much cash as needed; invest the excess in short-term investments.
- Accounts receivable levels: monitor receivables levels to ensure customers are paying promptly and providing cash flow to your business.
- Inventory levels: keep inventory as low as is reasonable for your business since the carrying costs associated with inventories are so high.
- Fixed assets: analyze your property, plant and equipment to see that these capital assets are being fully utilized and financed efficiently.
- Accounts payable: keep an eye on accounts payable to make sure the company has enough liquidity to pay its bills.
- Long-term debt: watch the company's debt-to-equity ratio and keep it in line with, or better than, industry norms.
Improving Your Balance Sheet and Using Income Statements
Although you can take steps just prior to the balance sheet date (generally, year end) to improve it, you should be aware of how your actions and decisions throughout the year affect the "balance sheet appearance" of your company that may be presented to outsiders.
Often, the individual balance sheet items can be improved to give a better-looking overall picture. For instance, you can improve cash balances by retaining cash collected on receivables until after the balance sheet date, rather than promptly spending the money.
Another area to watch, if you manufacture goods, is inventory. Since finished goods are more easily converted to cash than are raw materials, and also have a higher value, converting more raw materials to finished goods before the balance sheet date looks better when presented in the financial statements. Whatever your business, you may want to hold off on writing off receivables as uncollectable bad debts, or writing down marketable securities to reflect a decline in value (assuming the delays are justifiable).
Sometimes year-end planning to reduce taxes may be in conflict with year-end planning to improve financial statements. This is because higher income looks good on your financial statements, but can cause you to pay more income tax. In such a case, you may have to choose between paying higher taxes to make your company's financial statements look better, or foregoing improved statements to reduce taxes. Depending on the business and its needs, lower tax payments are not always your best choice.
The fact that a business owner can take steps to improve the balance sheet's appearance illustrates one of the shortcomings of the statement. To the extent that it can be manipulated, it becomes less reliable as an indication of a business's true financial condition.
If you are ever in the position of considering whether to buy or invest in another business, you can already see why it's worth looking beyond the balance sheet.
Besides improving the individual items shown on your balance sheet, you can also improve its appearance by improving your business ratios (or the relationship between certain items). To illustrate how you can do this, consider four key business ratios derived from balance sheet figures:
- two deal with the liquidity of the business (current ratio and quick ratio)
- two deal with the management of business debt (debt-to-equity and debt-to-assets ratios)
Working With Income Statements
While the balance sheet is a financial snapshot, giving you a picture of the business's assets and liabilities on a single day at the end of the accounting period, the income statement shows you a summary of the flow of transactions your business has had over the entire accounting period. In other words, the income statement shows you what happened during the period between balance sheets.
The income statement, also referred to as a "profit and loss statement," "statement of incomes and losses," or "report of earnings," tells you or your investors:
- the income the business has earned in the accounting period
- the costs or expenses that were incurred by the business during the period
- your net profit — the difference between the costs and income for the period
Three years' worth of income-statement data are normally presented, so that you can make comparisons and identify trends. The data consists of the following types of items:
- sales revenue
- sales returns and allowances
- other income
- cost of goods sold
- selling, general, and administrative expenses
- depreciation and amortization expenses
- interest expense
- income taxes.