A balance sheet, also known as statement of financial position is one of the most important financial statements a company will prepare. Companies prepare their balance sheet at the close of an accounting period; on a yearly, a quarterly or even monthly basis (depending on the frequency of financial reporting adopted).
Indicating your total assets, total liabilities, and net worth, a balance sheet gives a comprehensive view of the financial health of your business and can help tell lenders, investors and stakeholders about the current state of your business. The balance sheet is not an account and it is not part of the double entry system, therefore, there is no debit and credit side.
Maybe you are a novice in accounting and need to prepare a balance sheet for your small business and you can't afford to employ an accountant or outsource your accounting to an accountancy firm, this article covers all you need to know to understand how balance sheet works and why it is business fundamental and the general steps to prepare a basic balance sheet for your business.
What Is A Balance Sheet?
A balance sheet is a financial statement that shows the financial position of an organization. We calculate this by subtracting all the company’s liabilities and shareholder equity from its total assets over a period.
A balance sheet gives both internal and external analysts an overview of how a business is currently performing, how it performed in the past, and how it's expected to perform in the near future. This makes it an important tool for personal and investors, also for key stakeholders within an organization and outside regulators.
The purpose of a balance sheet is to give interested parties an insight of a company's financial position, it also shows what the company owns (assets), what it owes (liabilities) and what it is worth (equity).
Also Read: How To Prepare Trial Balance Sheet
Balance Sheet Equation
The balance sheet formula is explained below:
Assets = Liabilities + Shareholders’ Equity
The equation above includes three categories of value we must account for to prepare a balance sheet.
Components of a balance sheet
A Balance Sheet has three components: assets, liabilities, and owner's or stockholders' equity. It is like a scale of measurement. Assets and liabilities are normally out of balance by themselves until you add the business's net worth or equity.
The three components of balance sheet are explained below
An asset is a property of the company, i.e anything a company owns which holds some amount of quantifiable value. They are the goods and resources owned by the company.
Furthermore, they are classified into current and noncurrent assets.
1. Current Assets
Current assets are what a company expects to convert into cash within a short period, such as cash and cash equivalents, prepaid expenses, inventory, marketable securities, and accounts receivable. Current assets are temporary.
2. Fixed Assets
Also called Fixed assets, non current assets are not purchased for resale but are held to earn revenue for the company. They are long-term investments that a company does not expect to convert into cash in the short-term, such as land, equipment, patents, trademarks, and intellectual property. Fixed assets are naturally permanent.
Assets are also classified into Tangible and Intangible Assets. Tangible assets can be seen felt or touched, such as; land and building, motor van, plant and machinery, fixtures and fittings, etc. Intangible assets can't be seen felt and touched, such as patent, stock, investment, etc.
Also Read: Liabilities: What are liabilities in accounting?
A liability is anything a company owes to outsiders. Examples of liabilities are; payroll expenses, rent and utility payments, debt payments, money owed to suppliers, taxes, or bonds payable.
We classify liabilities as either current liabilities or noncurrent liabilities.
1. Current Liabilities
Current liabilities are obligations due within one year, which may include accounts payable and other accrued expenses.
2. Noncurrent Liabilities
Noncurrent liabilities are obligations that a company doesn’t expect to repay within one year and above such as leases, bonds payable, or long term loans.
3. Shareholders’ Equity
Shareholders’ equity is the net worth of a company, and it reflects the amount of money left over if a company sold all its assets and pay its liabilities. Shareholders’ equity belongs to the shareholders, either private or public owners.
We represent shareholders’ equity by the equation below:
Shareholders’ Equity = Assets - Liabilities
Does A Balance Sheet Always Balance?
A balance sheet should always balance. The name itself comes from the fact that a company’s assets will equal its liabilities plus any shareholders’ equity issued.
If your balance sheet doesn't balance, there's likely a problem with some of the accounting or bookkeeping data you've relied on. Double check to confirm that all of your entries are correct. You may have omitted or duplicated entries in assets, liabilities, or equity, or in most cases, miscalculated your totals.
Reasons Why Balance Sheet Will Not Balance
If when preparing your financial statement, you discover that your balance sheet doesn't balance, then it is caused by one of the following problems:
- Incomplete or misplaced data
- Incorrectly entered transactions
- Errors in currency exchange rates
- Errors in inventory
- Miscalculated equity calculations
- Miscalculated loan amortization or depreciation
How To Prepare A Basic Balance Sheet
How do you make a balance sheet from scratch? Here, we analyzed the steps you can take to prepare a basic balance sheet for your business. Even if you automate some or all the process through accounting system or software, knowing how to prepare a balance sheet will enable you to spot potential errors and resolve them before they cause lasting damages to your company or small business. Here are the basic steps to building a balance sheet:
1. Determine the Reporting Date and Period
A balance sheet shows a company's total assets, liabilities, and shareholders’ equity on a specific date, which is known as the reporting date. Usually, the reporting date is the last day of the reporting period.
Most companies, especially publicly traded ones, report quarterly. When this is the case, the reporting date will most usually fall on the last day of the quarter:
- First Quarter (Q1): March 31
- Second Quarter (Q2): June 30
- Third Quarter (Q3): September 30
- Fourth Quarter (Q4): December 31
Companies that report yearly will often use December 31st as their reporting date, though they can choose any date. It's common for a balance sheet to take a few weeks to prepare after the reporting period has ended.
Also Read: Retained Earnings On Balance Sheet
2. Identify Your Assets
After you’ve identified your reporting date and period, you’ll need to tally your assets as of that date.
A typical balance sheet will list assets in two ways: As individual line items (current assets and noncurrent assets) and then as total assets. Dividing assets into different line items will make it easier for analysts to understand what they are and where they came from; it is very important to tally them together for last analysis.
In accounting, we classify assets into the following line items:
- Cash and cash equivalents
- Short-term marketable securities
- Accounts receivable
Noncurrent Assets or Fixed Assets:
- Long-term marketable securities
- Intangible assets
Current and noncurrent assets should both be subtotaled independently and then totaled together to arrive at the total assets.
3. Identify Your Liabilities
Similarly, you will need to show your liabilities. Again, these are organized into both line items and totals, as below:
- Accounts payable
- Accrued expenses
- Deferred revenue
- Commercial paper
- Current part of long-term debt
- Other Current Liabilities
- Deferred revenue (noncurrent)
- Long-term lease obligations
- Long-term debt
- Other noncurrent liabilities
Liabilities are both subtotaled and then totaled together.
4. Calculate Shareholders’ Equity
If a company is privately owned by a single person, then calculating shareholders’ equity will be easy and straightforward. But if it’s publicly owned, this calculation may become more complicated depending on the various types of stock issued.
Some common items found in shareholders’ equity side include:
- Common stock
- Preferred stock
- Treasury stock
- Retained earnings
5. Subtract the total of Liabilities and Shareholders’ Equity from total assets
To balance the balance sheet, it is necessary to compare total assets against total liabilities plus equity. To do this, you have to add liabilities and shareholders’ equity, if the total is equal to the total assets, then your balance sheet is balanced.
Also Read: What is Capital in Accounting?
Depreciation Of Fixed Assets On The Balance Sheet
Depreciation is the reduction in the economic value of an assets. Fixed assets such as plant and machinery, motor van, furniture and fittings, etc depreciate after a period of time. When this happens, the amount of depreciation will be subtracted from the cost of acquiring the asset which gives us the netbook value.
NOTE: Land can't depreciate in value because it is infinite and doesn't have an expected life span.
Asset - cost of depreciation = Netbook value
When the cost of depreciation is subtracted from the cost of asset, the netbook value will represent the new cost of asset. The cost of depreciation will also be subtracted from the gross profit on the income statement (profit and loss account) as expenses.
What Is The Format Of Balance Sheet?
There are two formats for preparing the balance sheet, they are the vertical balance sheet format and horizontal balance sheet format. On the vertical format, all line items are presented down the left side of the page while on the horizontal balance sheet, all asset line items are listed down the first column and liabilities and equity line items are listed down the second column.
|Balance sheet format
Balance Sheet Sample
Example: Prepare a balance sheet as at December 31, .....
|Balance sheet sample
The basis of all financial reporting
Balance sheet is one of the most important financial statements which gives a quick overview of a company's financial health. Learning to prepare balance sheet and troubleshoot problems when they don’t balance can help you become an important member of your company.