The balance sheet is a snapshot of the company's financial standing at an instant in time. It shows the company's financial position, what it owns (assets) and what it owes (liabilities and net worth). A balance sheet is called that because it must always balance (i.e., assets = liabilities + net worth). The individual elements of a balance sheet change from day to day, reflecting the activities of the company.
Analyzing how the balance sheet changes over time will reveal important information about the company's business trends. The trends over time can give you information about your ability to collect revenues, how well you manage your inventory, and your ability to satisfy creditors and stockholders.
Assets show how the company uses its funds. The company uses cash or other funds provided by the creditor/investor to acquire assets. Assets include all the things of value that are owned or due to the business.
The liabilities and net worth on the balance sheet indicate the company's source of funds. Liabilities and net worth are composed of creditors and investors who have provided cash or its equivalent to the company. As a source of funds, they enable the company to continue in business or expand operations.
Liabilities are a company's obligations to creditors, while net worth is the owner's investment in the company. In reality, both creditors and owners are investors. The only difference is the timeframe in which they expect repayment.
The operating cycle, also known as the cash-to-cash cycle, is the process of using cash to purchase current assets that are to be sold at a profit and collected as cash. As an example, a company uses funds to purchase raw material inventory that is turned into finished goods inventory, sold at a profit to create a receivable and collected to become cash once again. This cash is then used to pay the supplier, with the profits left in the business.
Sound financial management of a company involves matching the sources and uses of cash so that obligations come due as assets mature into cash.
Here is an example of a Balance Sheet. It is always shown in two parts to reflect the accounting equation:
Assets = Liabilities + Owners' Equity
Individual items within each section are listed in a standard order. Cash and short term investments are shown first, then accounts receivable, and then inventory. For liabilities, trade creditors come first, then the short term bank loans, and then longer term loans.
Learn more about each section of the Balance Sheet:
Assets
Liabilities
Owners' Equity
