Understanding Balance Sheets: Assets, Liabilities, and Equity

A company’s balance sheet can help you analyze investments because it shows what a business owns, owes, and how much value belongs to shareholders. The balance sheet is built around three key components: assets, liabilities, and equity. They provide a snapshot of a company’s financial position at a specific point in time. By examining these elements, investors can better assess financial health, stability, and risk. When used with income statements and cash flow statements, the balance sheet becomes a powerful tool for informed investment analysis.

Understanding the Components of a Balance Sheet

A company's balance sheet comprises assets, liabilities, and equity. Assets represent things of value that a company owns and has in its possession, or something that will be received and can be measured objectively. Liabilities are what a company owes to others—creditors, suppliers, tax authorities, employees, etc. They are obligations that must be paid under certain conditions and time frames. A company's equity represents retained earnings and funds contributed by its shareholders, who accept the uncertainty that comes with ownership risk in exchange for what they hope will be a good return on their investment.

The relationship of these items is expressed in the fundamental balance sheet equation:

Assets = Liabilities + Equity

The meaning of this equation is important. Generally, sales growth, whether rapid or slow, dictates a larger asset base—higher levels of inventory, receivables, and fixed assets (plant, property, and equipment, or PPE). As a company's assets grow, its liabilities and/or equity also tend to grow in order for its financial position to stay in balance.

How assets are supported, or financed, by a corresponding growth in payables, debt liabilities, and equity reveals a lot about a company's financial health. For now, suffice it to say that depending on a company's line of business and industry characteristics, possessing a reasonable mix of liabilities and equity is a sign of a financially healthy company. While it may be an overly simplistic view of the fundamental accounting equation, investors should view a much bigger equity value compared to liabilities as a measure of positive investment quality, because possessing high levels of debt can increase the likelihood that a business will face financial troubles.

Different Formats of Balance Sheets

Standard accounting conventions present the balance sheet in one of two formats: the account form (horizontal presentation) and the report form (vertical presentation). Most companies favor the vertical report form, which doesn't conform to the typical explanation in investment literature of the balance sheet as having "two sides" that balance out.

Whether the format is up-down or side-by-side, all balance sheets conform to a presentation that positions the various account entries into five sections:

• Current assets (short-term): items that are convertible into cash within one year
• Non-current assets (long-term): items of a more permanent nature
• Current liabilities (short-term): obligations due within one year
• Non-current liabilities (long-term): obligations due beyond one year
• Shareholders equity (permanent): shareholders investment and retained earnings

How Accounts Are Presented on a Balance Sheet

In the asset sections mentioned above, the accounts are listed in the descending order of their liquidity (how quickly and easily they can be converted to cash). Similarly, liabilities are listed in the order of their priority for payment. In financial reporting, the terms "current" and "non-current" are synonymous with the terms "short-term" and "long-term," respectively, and are used interchangeably.

It should not be surprising that the diversity of activities included among publicly-traded companies is reflected in balance sheet account presentations. The balance sheets of utilities, banks, insurance companies, brokerage and investment banking firms, and other specialized businesses are significantly different in account presentation from those generally discussed in investment literature. In these instances, the investor will have to make allowances and/or defer to the experts.

Lastly, there is little standardization of account nomenclature. For example, even the balance sheet has such alternative names as a "statement of financial position" and "statement of condition." Balance sheet accounts suffer from this same phenomenon. Fortunately, investors have easy access to extensive dictionaries of financial terminology to clarify an unfamiliar account entry.

Why Dates Matter on a Balance Sheet

A balance sheet represents a company's financial position for one day at its fiscal year end—for example, the last day of its accounting period, which can differ from our more familiar calendar year. Companies typically select an ending period that corresponds to a time when their business activities have reached the lowest point in their annual cycle, which is referred to as their natural business year.

In contrast, the income and cash flow statements reflect a company's operations for its whole fiscal year—365 days. Given this difference in "time," when using data from the balance sheet (akin to a photographic snapshot) and the income/cash flow statements (akin to a movie) it is more accurate, and is the practice of analysts, to use an average number for the balance sheet amount. This practice is referred to as "averaging," and involves taking the year-end (2023 and 2024) figures—let's say for total assets—and adding them together, then dividing the total by two. This exercise gives us a rough but useful approximation of a balance sheet amount for the whole year 2024, which is what the income statement number, such as net income, represents.

The Bottom Line

A company’s balance sheet shows its financial position by breaking down assets, liabilities, and equity. This helps investors understand what the company owns, what it owes, and how its operations are financed, offering clear insight into overall financial health. The balance sheet can serve as a foundation for key performance metrics, including ROA, debt-to-equity (D/E) ratio, and liquidity ratios, making it an essential tool for financial analysis.