Balance sheet

by Admin
Updated: June 29, 2018

The balance sheet is designed to show how much a business is worth but you cannot rely on it

Two businesses that are equally profitable may not be equally valuable. One could have a surplus of cash whereas the other could have huge amounts of debt. The balance sheet is the financial statement designed to reveal this kind of information.

When a business is profitable, the balance sheet can normally be expected to take care of itself and is not seen to play a major role in the day-to-day operation of the business. It is also imperfect.

Nevertheless, when considered together with dividends and other disbursements to owners & investors, it provides an important snapshot indicating the overall health of the enterprise.

The meaning & the equation

The balance sheet is intended to show how much a business is worth and how that worth is composed.

Take for example a business that owns a building valued at $100,000, has $50,000 in the bank and outstanding sales invoices of $10,000. Its assets add up to $160,000. But if it owes $5,000 to its suppliers and its building is mortgaged for $80,000, its net worth - the balance - can be calculated as only $75,000 using the following balanced equation:

Equity = Assets - Liabilities

By convention, this is usually expressed as an explanation of assets:

Assets = Liabilities + Equity

Balance sheets are either two-column layouts with equal totals like this or single-column layouts written out in this order (assets, then liabilities, with equity at the bottom).

The mathematics then is quite simple. The problem is you cannot rely on the balance sheet because it can still paint an incorrect picture of the true value of a business.

Overvalue

By definition, a business is more than simply a pile of cash which means its other assets - those that are not cash and do not have a guaranteed sale price - must somehow be valued in terms of cash.

For example, if the balance sheet shows $20,000 for equipment originally purchased for $100,000 a few years ago, has it been aggressively depreciated or is it now obsolete and worthless?

Undervalue

The balance sheet doesn’t include self-created intangible assets or perceived value.

If you buy intellectual property for a sum of money then it will appear on the balance sheet with that valuation. If you develop technology, accumulate data etc. in-house, it cannot be shown on the balance sheet because its fair value has not been established (because it hasn’t been sold yet). This is similarly true for brand recognition, customer loyalty and so on.

From an accounting perspective, this has many benefits. However, when it comes to trying to sell the company or some aspect of it, the balance sheet may not be very useful in determining the price.

Off balance sheet items

It can become complicated, but if assets can be left off the balance sheet, so too can liabilities!

This is not quite the dreadful loophole it seems: While such things (guarantees, legal contingencies etc) are not on the balance sheet itself, they should still be recorded in the notes to an extent required by law.

More info

Balance sheet explanation at accountingcoach.com.

“Do Investors Overvalue Firms With Bloated Balance Sheets?” PDF (796 kB) hosted by haas.berkeley.edu.

Hidden Asset Case Study PDF (1.4 MB) from boyarresearch.com.

Off balance sheet items are described with an example at investinganswers.com.

Internal links

Depreciation and revaluation Financial reconciliation Profit Go to Articles
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