A company’s financial position statement consists of three main statements, one of which is the balance sheet. The balance sheet states what a company owns, which are its assets, what it owes, which are its liabilities, and what the shareholders have invested, which is its equity.
The objective of the balance sheet is to provide an insight into a company’s financial position at a particular point in time by showing the company’s assets, liabilities and equity. The balance sheet enables a company’s management to obtain an understanding of the financial position in order to optimise its financing structure, make informed decisions on investments and their financing and identify financial risks. The balance sheet helps investors, creditors and analysts to evaluate a company’s financial strength and performance by providing information about its liquidity, solvency, and capital structure. It also allows stakeholders to see how the company’s resources are being used and how its financing is structured.
There are a number of ratios that are commonly used to assess a company’s financial position:
- Current ratio: This ratio measures a company’s ability to pay its short-term liabilities with its short-term assets. It is calculated by dividing current assets by current liabilities.
- Quick ratio: This ratio is similar to the current ratio, but it excludes inventory from the calculation of current assets. It provides a more conservative measure of a company’s ability to pay its short-term liabilities.
- Debt-to-equity ratio: This ratio measures a company’s leverage by comparing its total liabilities to its shareholders’ equity. It provides information about the level of risk associated with a company’s capital structure.
- Debt-to-assets ratio: This ratio measures the proportion of a company’s assets that are financed with debt. It is calculated by dividing total liabilities by total assets.
- Return on equity (ROE): This ratio measures a company’s profitability by comparing its net income to its shareholders’ equity. It provides information on how effectively a company is using its equity to generate profits.
- Return on assets (ROA): This ratio measures a company’s profitability by comparing its net income to its total assets. It shows how effectively a company is using its assets to generate profits.
- Asset turnover ratio: This ratio measures a company’s efficiency in using its assets to generate revenue. It is calculated by dividing a company’s total revenue by its total assets.
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Balance sheet mechanics
The balance sheet adheres to the following accounting equation, with assets on one side, and liabilities plus shareholder equity on the other:
Assets = Liabilities + Shareholders’ Equity
This equation provides a check on the accuracy of the balance sheet and ensures that the financial information presented is complete and balanced.
The assets section of the balance sheet lists all the items that a company owns or has a claim to and that are expected to generate future economic benefits. Assets are classified as current or non-current assets, depending on whether the amount is recovered within or after 12 months. A presentation based on liquidity may also be used.
Non-current assets: These are assets that are not expected to be converted into cash within one year, such as property, plant, and equipment, long-term investments, and intangible assets;
Current assets: These are assets that can be easily converted into cash within one year, such as trade receivables, inventory, marketable securities and other current receivables.
The liabilities include all the items that a company owes to others. Liabilities are classified as current or non-current liabilities, depending on whether the amount is settled within or after 12 months.
Non-current liabilities: These are liabilities that are not due within one year, such as loans and borrowings, deferred tax liabilities, and pension obligations.
Current liabilities: These are liabilities that are due within one year, such as trade payables, repayments of loans and borrowings within the next 12 months and accrued expenses.
Equity represents the residual interest in the assets of a company after deducting its liabilities. It includes common stock, additional paid-in capital, retained earnings, and accumulated other comprehensive income.
The balance sheet
Given the importance of the balance sheet, it is essential that the amounts presented are accurate. Ensuring the accuracy of the balance sheet may involve the following:
The Fidugius solution and your balance sheet
The Fidugius Accounting & Reporting Manual is a solution that helps companies improve the reliability of their balance sheet by providing guidance on how to maintain accurate records through appropriate accounting policies, definition of accounts and accounting treatments. The manual also serves as a training and education resource for new staff members and as a reference for auditors.