The balance sheet is an important document for investors and analysts alike, and it is very important to understand how the balance sheet works on the basis of its simple accounting equation, and to understand all the accounts and mathematical and financial terms associated with them. The purpose of the balance sheet is to present and classify accounts of assets and liabilities and The company’s capital is only in accordance with the principles and permitted accounting laws to help the budget users from investors and financiers, and in this article we will show you all the information related to the balance sheet in terms of definition, components and how to prepare it.
The accounting cycle passes through several stages, the first of which is the recording of daily financial movements or entries and ends by producing and presenting financial statements for a specific financial period.
And the balance sheet is one of these financial statements, and in general the financial statements consist of 4 lists, which are:
- Income list.
- Statement of Cash Flows.
- List of changes in property rights.
- Balance sheet.
What is a balance sheet?
The balance sheet is a financial statement that indicates a company’s assets, liabilities, and shareholder equity at a specific point in time, and provides a basis for calculating rates of return and evaluating the capital structure.
It is a financial statement that provides a quick overview of what the company owns and owes, as well as the amount invested by shareholders, and the balance sheet is used in conjunction with other important financial data such as the income statement and the cash flow statement in performing basic analysis or calculating ratios.
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Formula Used for a Balance Sheet
As for the form of the balance sheet equation, there is a special formula for it, whereby the balance sheet adheres to the following accounting equation:
- Assets = Liabilities + Equity
In fact, this formula is very intuitive, as the company has to pay for all the things it owns (assets) either by borrowing money (incurring liabilities) or taking it from investors (issuing equity).
For example: If a company takes a five-year loan of $ 4,000 from a bank, it will increase its assets by $ 4,000. Its liabilities will increase by $ 4,000, which will balance both sides of the equation.
If the company gets $ 8,000 from investors, it will increase its assets by this amount, as well as shareholders ’equity, and all revenues that the company achieves that exceed its liabilities will be entered into the shareholders’ equity account, which represents the net assets owned by their owners.
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What’s on the balance sheet?
The balance sheet represents the state of a company’s finances at a point in time, and it cannot give a sense of trends that can last for a long time in itself, and for this reason, the budget must be compared to the budgets of previous periods.
Also, those budgets of other companies in the same industry should be compared since different industries have unique methods of financing, and a number of ratios can be obtained from the balance sheet, which helps investors understand how healthy the company is.
In general, the balance sheet consists of three main sections, which are:
- Assets = Company’s property.
- Liabilities = Debts owed by the company.
- Capital, Equity, or Shareholders’ Equity = the total value or wealth of the company after collecting its assets and subtracting its liabilities.
First | Assets:
It is the property of the facility, including warehouse goods, car furniture, buildings, machinery, equipment, land, cash and debts accumulated by customers, etc., and the assets are classified in order to: current assets (current) and fixed assets (long term).
1) Current assets
They are called short-term assets, which are the property of the company that is expected to turn into liquidity within one year only, and it is arranged according to its liquidity starting from the account with the highest liquidity to the least liquid.
What is meant by liquidity is the ability to convert the company’s assets or assets into cash in an easy and fast manner, so the first account that the current assets contain is the cash account, and in the following list there is a general arrangement of the traded assets according to liquidity (from high to low):
- Cash: the cash in the box or safe of the company or banks
- Rapid convertible securities: the company’s investments from stocks and bonds, which are easy to convert into cash and whose maturity does not exceed one year.
- Accounts receivable: debts accumulated or owed by customers
- Goods stock: Goods that are available and in stock for sale
- Pre-paid expenses: such as paying insurance on vehicles and buildings and building fees for a full year in advance
2) Fixed assets
They are called long-term assets, and they are the properties of the company that are not traded, meaning that they remain in the company’s possession for a long period that exceeds a year, such as land and equipment, and this branch of assets is used as a long-term investment to generate income or profit.
Second | Obligations
The so-called liabilities are the debts accumulated on the company that must be repaid over time, such as bank loans and purchases on the account, and liabilities are classified into: current obligations and long-term liabilities.
1) Current liabilities
They are called current liabilities and they are debts that accumulate on the company and must be paid or repaid within a year, and the following list shows the most prominent current liabilities that accumulate in the company’s accounts:
Accounts payable: are the debts that accumulate on the company towards suppliers or merchants (purchase on account).
Payroll receivables: It is the debts that accumulate on the company towards employees who have not yet received their salaries.
Unearned revenue: it is the goods or services that customers paid for in advance before receiving them, so they are not recognized as sales yet.
Bills payable: They are short-term loans whose maturity does not exceed a year, and the company must pay the value of this loan within one year only.
2) Long-term liabilities
They are the debts that the establishment borrows and needs to be repaid within a period of time that exceeds a year, for example, a bank loan of a certain value for a period of four years is withdrawn, and a certain amount of the loan is scheduled weekly or monthly according to the agreement until the end of repayment of the entire loan with the end of the fourth year.
Third | Capital
It is the total value or wealth of the company after collecting its assets or properties and subtracting its liabilities or debts, and capital is the entitlement of the owners of the facility or company over all the assets after paying the liabilities or debts owed by the company.
Limitations of Balance Sheets
The balance sheet is valuable information for investors and analysts, however, it does have some drawbacks, because it is just a piece of information that comes at the right time, it can only use the difference between that point in time and one point in time in the past.
The balance sheet is a summary of an organization’s financial balances. Assets, liabilities, and equity are listed as of a specific date, such as the end of the financial year. In fact, the balance sheet is described as a snapshot of the company’s financial position.
This is because the balance sheet is the only statement that applies to one point at a time in the company’s calendar year, and this means that fixed assets will appear in the balance sheet at historical cost less depreciation to date, and that in turn will affect the book value of the asset in the balance sheet.
That is, the balance sheet is prepared based on the historical cost, and this means that the cost will be equal to the book value only if there is no recorded change in the value of the asset since the purchase, and the historical cost is criticized for its inaccuracy because it may not reflect the current market evaluation.
One of the other limitations on the balance sheet is that some current assets are valued on a discretionary basis, and thus the balance sheet cannot reflect the real financial position of the company,
And intangible assets such as goodwill appear in the balance sheet in fictional numbers, which may not have anything to do with the market value.
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How to prepare the balance sheet from the trial balance
In the beginning, it is necessary to define the trial balance before explaining how to prepare the balance sheet from the trial balance, as the trial balance is an accounting report in which the balances are listed in each of the company’s general ledger accounts except for the accounts that have zero balances.
The trial balance is not a financial statement, but rather an internal report that is useful in a manual accounting system, as it indicates in the event of an imbalance of debit and credit accounts balances that there is an error compared to the journal.
To determine how to prepare the balance sheet from the trial balance, you simply have to rearrange the items or accounts in the trial balance on the balance sheet as assets are moved to the left side and liabilities and equity are to the right side.
Also, when preparing the balance sheet from the trial balance, the following should be taken into account:
- Determine the value of assets in the correct sequence for them.
- Distinguish between current and fixed assets, as well as write all the details of their elements, and then calculate their financial value.
- Determine the value of obligations in the correct sequence for them.
- Distinguish between short, medium and long-term liabilities along with all the details of their components, and then calculate their financial value.
- Ensure that total assets are equated with total liabilities and equity.