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Introduction to Balance Sheets

If you have a company in San Diego (or work at one), having a basic understanding of balance sheets is an important skill. The balance sheet provides crucial information about a business and is one of the key ways of communicating it’s financial circumstance and performance. Unless you are an accountant or analyst you may not need to understand all of the finer points, but knowing the basics is key if you want to understand how businesses function. Because we love the San Diego business community, we decided to put together this introduction to balance sheets for your convenience. So strap on your thinking cap and get ready for balance sheet basics.

What is a Balance Sheet?

The balance sheet is one of the three core financial statements of a company. It gives an overview of a company’s assets, liabilities and shareholders’ equity at a given point in time. The balance sheet is based on the fundamental accounting equation which states that the sum of assets and liabilities equals shareholders’ equity. The logic behind this can be explained in many different ways, but one of the more intuitive explanations is that all assets must have been acquired either through taking on debt (liabilities), or investing capital directly (equity). Hence A = L + E.

A man walks along rope across a cliff, symbolic of balance and therefore balance sheets.
If you want you balance sheet to balance as well as this guy be sure to read our entire introduction to balance sheets. (We really hope this guy didn’t fall. That looks high…)

The Components of a Balance Sheet

In this section we’ll break a balance sheet into its major parts and give examples of the kinds of things you will see there. Read on!

Assets

1. Current assets

The fancy definition of an asset is a resource that an entity owns from which future economic benefits are expected to flow. Put more simply, an asset is something of value that a company owns. (See below for some examples.) They can be divided into two major categories: Current Assets and Fixed Assets.

Current assets are assets that a company expects to use or sell within a year. Common examples of current assets include inventory, cash & cash equivalents, and accounts receivable.

Inventory

Raw materials or supplies used in the production of goods for sale, work-in-progress, and the final finished products that a business holds may all be considered inventory.

Cash and Cash Equivalents

The term cash and cash equivalents is used to describe the value of a company’s items that are cash or can be readily converted to cash. For most small and medium-sized businesses this basically just means cash. Some companies; however, may also own highly liquid assets such as T-bills that can easily be exchanged for cash and are thus considered an ‘equivalent’.

Accounts Receivable

Accounts receivable, also known as AR, represent the amount an entity is owed by its customers for goods and services.

2. Fixed Assets

Unlike current assets, fixed assets (or long-term assets) are assets that a company plans to own and utilize for a longer time frame, often many years.

Property, Plant, and Equipment (PP&E)

PPE are tangible fixed assets such as its equipment, land and buildings. If a business owns a factory, for example, that would be an example of PP&E. All PPE, except for land, is depreciable.

What is depreciation? Depreciation is the way that fixed assets both decrease in face value over time, and the way in which they are expensed. Most items that a business buys are immediately expensed. If you buy paper clips, they are expensed, deducted from revenues, and decrease profit. But when a fixed asset is purchased it isn’t expensed at all. Instead, it is just put on the balance sheet. Then, each year it is depreciated which both decreases it’s value (naturally, as a piece of machinery gets older it loses value) and creates an expense. So, if you buy a very expensive piece of machinery, instead of a massive expense in year one, it will slowly be expensed over a long period, for example fifteen years.

Liabilities

The fancy definition of liabilities are obligations to transfer economic resources as a result of past events. Put more simply, liabilities are things that a business owes to others. Like assets, they can be broken into current and non-current forms.

1. Current Liabilities

Current liabilities are obligations which an entity must settle within a year. Basically, the liability version of a current asset. Examples of current liabilities include accounts payable, dividends payable, and the current portion of long-term debt.

Accounts Payable (AP)

Accounts payable, also referred to as AP, represents the amount an entity owes its creditors and suppliers in return for goods and services.

Dividends Payable

Dividends Payable represent the amount of dividends that an entity has announced to investors but not yet paid. This is more relevant to public companies than your typical small to medium sized San Diego business.

Current Portion of Long Term Debt

The current portion of long-term debt means exactly what it sounds like. That is, the portion of a long-term debt obligation that will be paid in the short term. So, if your business owes a million dollars, but will pay off $50,000 this year, that would be the current portion.

A stressed woman grabs her hair, like you might if you have too many liabilities on your balance sheet.
Too many liabilities on your balance sheet may leave you as stressed as this chic. Don’t be like her. Finish our introduction to balance sheets so you are armed with knowledge.

2. Long Term Liabilities

Non-current liabilities are obligations which will be settled by an entity over a period longer than a year. Examples include bonds payable, debentures, long-term loans and long-term lease obligations.

Bonds Payable

Bonds payable are the amount owed by an entity to lenders to whom it has issued bonds. (Again, not particularly common among local SD businesses, but a common liability nevertheless.)

Debentures

Debentures sound really fancy but are just a type of unsecured bond which often has a longer maturity. In spite of the name, they have nothing to do with dentistry.

Long Term Loans / Long Term Lease Obligations

As you might expect, amounts in these categories represent loans or leases that are expected to be held longer than a year, or the portion of them which is expected to be held longer than a year. (As noted above, the portion expected to be paid would be the ‘current portion’ of the obligation.)

Equity

Equity represents the value of a company after all of the liabilities are deducted, also known as the book value of the company. If we use some basic algebra to move around the variables in the fundamental accounting equation, we can get Equity = Assets – Liabilities.

Common examples of equity include owner’s contributions and retained earnings.

Owner’s Contributions

Smaller businesses often use this category which represents funds invested into the company by the owner.

Retained Earnings

Retained earnings are an ongoing tally of your profit after all direct and indirect costs, taxes and dividends have been paid off. After each year is completed, the profits are added to the retained earnings account, where they will stay until they are used or distributed to the owners.

Balance Sheet Ratios

Creating ratios using data from the balance sheet can be a good way to gain insights into the health of a business. Banks, for example, may consider various balance sheet ratios when deciding whether to give a business a loan, and in some cases a lender will require a business to maintain minimum amounts for certain ratios. Likewise, investors often check balance sheet ratios when deciding whether to invest, and owner’s use them to review the health of their company.

Current Ratio

The current ratio is assets divided by liabilities.

The current ratio is the ratio of current assets to current liabilities. A current ratio is indicative of a company’s ability to pay off its current liabilities using its current assets and is a way of measuring liquidity and solvency. If there are a lot more current liabilities than current assets, you may worry whether the company will be able to meet its debt obligations. Hence, a higher ratio is often considered desirable. (Believe it or not, an unnaturally high ratio is also sometimes considered undesirable because it may imply an inefficient use of resources, but don’t worry if that doesn’t make sense, it’s a bit of an advanced concept.)

Quick Ratio

The Quick Ratio is current assets - inventory divided by current liabilities.

The quick ratio is very similar to the current ratio; however, inventory is deducted from the current assets. Because inventory is deleted, this is considered a more stringent determination of liquidity and the ability to pay your obligations. Why? Because it may be difficult to sell off your inventory at face value in order to pay off debt, so in this case it isn’t included as an indication of how solvent you are.

Gearing Ratio

The Gearing Ratio is debt divided by debt plus equity.

The gearing ratio is the ratio of the entity’s debt to its equity. A high gearing ratio often indicates that the financial risk of a business is high because it is holding a relatively high debt load.

Receivables Collection Period

The receivables collection period equals accounts receivable divided by net credit sales times 365 days.

The receivables collection period indicates the average number of days for which a receivable is outstanding. For liquidity purposes, a shorter receivables collection period is generally considered better because it means you get paid faster.

Average Payment Period

The Average Payment Period equals average accounts payable divided by credit purchases divided by the number of days.

The payables payment period indicates the average time it takes for an entity to pay its suppliers. While a longer payment period may be considered better for liquidity purposes, taking too long to pay may damage an entity’s relationships with its suppliers.

Inventory Holding Period

The Inventory Holding Period equals average inventory divided by cost of goods sold times 365.

The inventory holding period indicates the average time the entity is holding its inventory before it is sold or used. A shorter inventory holding period is considered better for liquidity purposes. Furthermore, a shorter inventory period reduces the chance of inventory getting damaged or obsolete. However, the entity should draw a balance between inventory held and sold. There should be appropriate levels of inventory in the storage to ensure there are no production stoppages or delayed deliveries to customers.

Balance Sheet Conclusions

So there you have it – My SD Bookkeeper’s (more about us in a bit) introduction to balance sheets. We hope you have a basic understanding of the balance sheet at this point. At it’s essence, the balance sheet is a snapshot of a company in time that describes it’s financial position at a given moment, and in doing so helps to provide insights into its functioning. It is rooted in a central concept in accounting, that is: assets are equal to liabilities to equity – always. Like, always always.

If you really want to understand a company than a balance sheet is only the beginning. There are two more extremely important financial statements – the income statement (also known as the profit and loss statement), and the statement of cash flows. When you combine all three of these you can get a remarkably strong understanding of a company.

Need a great general reference? Try Investopedia. They’ve got a lot of great resources on business and finance.

Want to read some more cool stuff? Check out this article on the 3 best payroll services for San Diego businesses? Or, if you love San Diego as much as we do, check out this one on 5 great things about running a SD business.

Who are we? We’re My SD Bookkeeper. We’re a bookkeeping, accounting, and business advisory firm that serves the greater San Diego community. If you’re in San Diego county and need help with any kind of back office operations then give us a call because we’d love to help. We work with companies across industries, including real estate and medical offices, to name a few – so we can help no matter what you do. Give us a call today, and best of luck with whatever your business ambitions may be!

More of a visual learner? Check out the great video introduction to balance sheets below.

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