Balance Sheet (Statement of Financial Position)
1. Definition
The Balance Sheet is a financial statement that provides a snapshot of a company's financial position at a specific point in time (e.g., as of December 31).
While the Income Statement represents financial performance over a period, the Balance Sheet represents the financial state at a single moment. It serves as the foundation of accounting.
2. The Accounting Equation
The Balance Sheet is governed by the fundamental accounting equation, which dictates that both sides must always balance.
$$ \text{Assets} = \text{Liabilities} + \text{Equity} $$
- Assets: What the entity owns (Use of funds).
- Liabilities: What the entity owes to outsiders (Source of funds - Debt).
- Equity: The net worth belonging to shareholders (Source of funds - Ownership).
3. Key Components
A. Assets
Listed in order of liquidity (how quickly they can be converted to cash). * Current Assets: Assets expected to be converted to cash within one year (e.g., Cash, Inventory). * Non-Current Assets: Long-term assets used for operations or held for investment (e.g., Property, Plant, Equipment).
B. Liabilities
- Current Liabilities: Obligations due within one year (e.g., Accounts Payable).
- Non-Current Liabilities: Long-term financial obligations due after one year (e.g., Bonds payable).
C. Equity
- Paid-in Capital: The capital actually contributed by shareholders.
- Retained Earnings: The cumulative net income retained in the business for reinvestment rather than distributed as dividends.
4. Why It Matters
- Liquidity Assessment: Checks if the company has enough current assets to cover its short-term debts.
- Solvency Analysis: Through the Debt-to-Equity Ratio, it evaluates financial stability and how much leverage the company is using.
5. Limitations
- Static View: It only reflects the financial position on a specific date, failing to capture fluctuations immediately before or after that date.
- Historical Cost: Assets are often recorded at their original purchase price (Book Value), which may differ significantly from their current Market Value.