What is a balance sheet?

The balance sheet is important because it tells investors how much the company has in assets (e.g., cash and property) and liabilities (e.g., how much money it owes to vendors, banks, and bondholders).

Like your net worth, balance sheets are only for a specific point in time; they’re a snapshot of a company’s net worth. This is unlike the income or cash flow statements, which cover periods such as a quarter or year.

Just as you might determine your personal net worth by subtracting your liabilities from your assets, the balance sheet follows a similar formula to establish shareholders’ equity.

For all intents and purposes, shareholders’ equity is a company’s net worth. This dollar amount would be returned to shareholders if the company’s assets were liquidated and its debts settled.

This is a typical balance sheet layout that a company will share with investors. However, it is important to note that the company’s management teams may use discretion in the language and terms they use on any financial statement, including balance sheets. This means that balance sheets from different companies can look a little different.

What are assets?

Assets are any item of property owned by the company that has value. Assets are ordered, from top to bottom, in order of liquidity, which means how quickly something can turn into cash.

Current assets are expected to be sold, used, or exhausted through standard business operations within one year. This includes assets like cash, accounts receivable, and inventory.

Long-term assets are expected to benefit the company for longer than a year. These include tangible assets (things that can be touched) such as real estate, factories, and equipment. They also include intangible assets (things that can't be touched), such as goodwill from past acquisitions, copyrights, and patents.

Going line by line through the asset section

Cash and cash equivalents refer to cash in a checking account but also include other short-term assets, such as Treasury Bonds or CDs, within a few months of maturity. For the equivalent in your personal life, this is the money in your checking account.

Marketable securities are assets that can be readily turned into cash, such as Treasury Bonds or CDs with slightly longer maturity dates. It can also include stocks that a company is holding for short-term purposes. In your own life, these would be assets you might hold such as CDs or bonds with maturity dates six months out.

While this sometimes includes other things from the balance sheet, when companies refer to how much “cash” they have, it will usually be a sum of cash equivalents and marketable securities.

Accounts receivable are when a company has delivered a good or service, but not yet been paid for it.

Inventory is a company’s products that are for sale, but have not yet been sold.

Finally, the last item listed under current assets is prepaid expenses. Prepaid expenses are any service the company has paid for in advance, such as insurance or an annual subscription.

Long-Term Assets are assets that are expected to benefit the company for more than the next twelve months.

Long-term investments are assets that cannot easily be turned into cash within one year. In your personal life, this is like money held in a retirement account. It can be accessed, but not without difficulty and penalties.

Fixed assets are usually physical assets, such as land, machinery, buildings, and equipment, much like your home.

Goodwill might be the most difficult term to understand on the balance sheet. It is an intangible asset representing the premium paid over the fair market value for an acquisition. Under accounting rules, goodwill is audited regularly to ensure it is still worth what it was when the acquisition was initially closed. Goodwill values can be adjusted down if conditions worsen.

Intangible assets, unlike fixed assets, are things that benefit companies that you can’t touch. This could be intellectual property or patents that the company holds. In your personal life, this is roughly the same as a degree or professional certificate you earned.  

Other long-term assets are a catch-all category for things such as client lists, trademarks, brands, or even more esoteric things such as hedging programs that the company might have.

What are liabilities?

Liabilities are all of a company's financial obligations owed to others.

Liabilities are ordered on the balance sheet from top to bottom regarding how soon the debt is due.

Current liabilities are bills due within the following year. This could include wages owed to workers, money owed to suppliers, and taxes owed to the government.

Long-term liabilities are debts not expected to be paid off in the next twelve months. These could include interest and payments on long-term debt, worker pension programs, and taxes not due within a year.

Going line by line through the liabilities section

Let’s now review the liability side of the balance sheet.

Accounts payable occur when a company receives goods or services for which it did not pay upfront but used credit. When you’re out to dinner with a friend who foots the bill until you pay them back, this is roughly the equivalent of accounts payable.

Accrued expenses are liabilities that the company has taken on through its normal operations but has not yet paid. Examples include employees’ wages between paydays, which are accrued before workers are paid for their labor. Other examples include a business’s utility bill or taxes.

Short-term debt is what a company owes on loan interest or principal on bonds it has issued that is due within the next year. In our personal lives, this is similar to the debt expenses we owe on our credit cards.

Long-term liabilities are debt that is not due to be paid beyond the next twelve months.

Long-term debt is any interest or principal on bonds that is not due within the next twelve months. Think of a homeowner’s 30-year mortgage. Any mortgage payments scheduled beyond the next twelve months would fall into this category.

Other long-term liabilities can include things such as back taxes for which a company has agreed to a multiyear payment plan or pension liabilities.

Convertible debt is another important term investors need to know if they want to analyze a company’s balance sheet. It is debt that, in lieu of being paid off, can be converted into stock ownership at a certain date at an agreed-upon price.

Investors might also often see the term note, which is a legal document representing a loan's terms, including the interest rate and payment schedule.

Finally, it is important to note that investors can find positive elements on the company’s liability side of the balance sheet.

For instance, deferred revenue is cash already collected for a good or service that the business has yet to deliver. Companies cannot count this prepayment as revenue until that product or service is delivered to the customer.

What is shareholder equity?

Shareholder equity is the equivalent of a person’s net worth on paper. This is the dollar amount that would be returned to shareholders if all of the company’s assets were liquidated and its debts settled. Alternatively, this is also referred to as a company’s book value.

The shareholders’ equity section of the balance sheet contains many useful categories for investors to examine.

Preferred stock or preferred shares is equity that gives its shareholders certain rights. For instance, preferred shareholders have a higher claim on a company's assets and earnings than common shareholders (but still less than bondholders).

Retained earnings are the cumulative profits a business has kept since its inception.

Additional paid-in capital is the money that shareholders have invested.

Treasury stock is the value of the shares that a company has repurchased.

In your search for investments, the balance sheet reveals whether a company borrows to keep the lights on or holds a hidden undervalued asset. Investors can learn if a company’s debt is worth more than its assets, giving it a negative book value. These are all critical factors prudent investors should want to know before investing their funds in a business.

Understanding these key terms and how each was reached will help you become a better investor.

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