Every company has a balance sheet — a financial document that provides a snapshot of the company's equity, assets, and liabilities at a given moment. Along with the income statement and cash flow statement, it serves as a key sign of the company's financial health and stability.
The basic formula for a balance sheet is:
Total assets = total liabilities + total equity.
What do these metrics mean?
The assets are what a business owns, the liabilities are what it owes, and equity is the shareholders’ stake in the company.
Why analyze accounting assets and liabilities?
Analyzing accounting assets and liabilities gives you an insight into a company’s liquidity, financial health, solvency, and capital structure. Can it meet its long-term obligation? What is the business’s potential to grow and expand? You can find the answers to all these questions and more by analyzing a balance sheet.
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What is the difference between active and passive assets?
Active assets are those that directly generate income. Companies often use passive assets for investment or as a means of protecting wealth rather than actively contributing to the overall profit of the company.
Active assets:
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inventory and equipment;
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accounts receivable;
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patents.
Passive assets:
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investments in securities (stocks, bonds, etc.);
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long-term deposits and savings;
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real estate investment.
What are the types of assets?
There are two main types of assets, based on their liquidity: current and non-current assets. Let’s take a closer look at them.
Current assets
A company can easily turn current assets into cash within one accounting year or its operating cycle.
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Cash and cash equivalents are highly liquid assets: cash, bank balances, and short-term investments that are easily convertible to cash (like treasury bills and money market funds).
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Suppose a company delivered some goods or services, but the customers haven’t paid for them yet. The money they owe is accounts receivable. They are highly liquid, so they can serve as an important source of short-term cash flow.
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Inventory includes raw materials, goods not yet completed, and finished products ready for sale. Inventory value is essential for companies in such industries as manufacturing and retail, because it directly influences sales and revenue.
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Marketable securities are the assets that the company can quickly buy or sell on a market. These are mutual funds, stocks, and bonds.
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Prepaid expenses are also current assets. The company has paid for some goods or services, but it will receive them in the future. For example, they are insurance, rent, advertising expenses, leased equipment, and estimated taxes.
Current assets are important indicators of a company’s short-term financial health and its liquidity. The more current assets it has, the better. However, the number of current assets can vary from one industry to another. In service-based companies it is lower, while retail businesses have more current assets.
Non-current assets
Non-current assets are vital for the business’s growth and can’t be converted into cash within a fiscal year.
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Land, buildings, vehicles, and equipment used for production or service delivery are tangible assets. Tangible means they have physical substance. These assets are essential for day-to-day operations in many industries. Sometimes they are referred to as PP&E — property, plants, and equipment.
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There are also non-physical, or intangible assets, for example any kind of intellectual property: patents, trademarks, goodwill, copyright. These assets can contribute to a company’s position on the market. Intangible assets are usually not listed in a balance sheet.
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Long-term investments which are held for long periods (more than a year): real estate, stakes in other companies, bonds and the like. Unlike marketable securities, they serve strategic or long-term growth purposes.
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Long-term receivables refer to the money that other businesses of clients owe to the company, for example installment sales or loans. This debt is paid over a period longer than one year.
The table below shows the key differences between current and non-current assets.
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Current assets
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Non-current assets
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Purpose
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Ensure liquidity in the short-term
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Support long-term business operations and growth
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Liquidity
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Highly liquid
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Highly illiquid
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Financial impact
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Important for meeting short-term obligations
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Crucial for long-term planning and management
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What are the types of liabilities?
Just as with assets, current and non-current are the two types of liabilities. The main difference is the time when a company meets the obligations.
Current liabilities
Current liabilities are obligations that a company is required to fulfill within one accounting year or its operating cycle. They too show the business’s liquidity and the ability to meet its immediate financial obligations. Current liabilities are often settled with current assets.
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Accounts payable is the sum the company owes for goods or services. They are usually due within several months depending on the contract.
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Short-term loans that the company must repay within a year, for example bank overdrafts or other short-term financing arrangements.
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Accrued expenses refer to costs that have been incurred but are not paid yet, such as taxes, wages, and utilities.
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Dividends payable are usually settled within a few months of declaration.
Current liabilities are important when estimating a company's ability to meet its short-term obligations without needing any additional financing.
Non-current liabilities
Non-current liabilities include long-term financial obligations.
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Long-term debt can include bank loans, corporate bonds, mortgages, or other financing arrangements that a company must pay off in more than one year (usually over several years).
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Long-term lease payments.
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Deferred tax liabilities are taxes that a company does not have to pay immediately.
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Pension obligations are future payment for retired employees if a company offers pension plans.
Here are the key differences between current and non-current liabilities.
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Current liabilities
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Non-current liabilities
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Purpose
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Finance short-term needs
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Finance long-term needs
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Duration
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Are due within one year
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Are due within several years
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Financial impact
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Directly affect liquidity ratios
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Affect solvency ratios
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The passive/active indicator: what is it and what is its function?
The passive/active indicator is a valuable tool for measuring financial health and solvency, evaluating possible risks, supporting well-weighed decision making, and analyzing capital structure. It shows the correlation between a company's liabilities (passive) and its assets (active). The formula for this indicator is:
Passive/active indicator = Total liabilities / Total assets.
What does this mean?
If the indicator is greater than 1, that means the liabilities exceed assets, which poses a financial risk. If it is less than 1, that’s assign of stability, as the company’s assets exceed its liabilities.
Another important indicator: current liquidity
Current liquidity is a crucial indicator of a company's ability to meet its short-term financial obligations. To assess it, you can analyze the working capital ratio: just divide the assets by the liabilities. If the result is greater than 1, the company is financially healthy and can cover its short-term liabilities with its short-term assets. If the working capital ratio is less than 1, this signals that the company may have liquidity problems and struggles to meet its short-term obligations.
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Frequently asked questions (FAQ)
What are other financial ratios for analyzing balance sheets?
There are other financial ratios that help you further analyze the data on a balance sheet.
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To calculate the debt-to-equity ratio (D/E ratio), divide the company’s total liabilities by shareholders' equity. That’s how you can learn more about the company’s financial leverage. A higher D/E ratio indicates that the company relies heavily on borrowing to finance its growth. This can be risky for investors if profits drop. A lower D/E ratio suggests that the company has more capital on its own and relies less on debt. This implies lower risk and more stability. Industries like financial services and utilities usually have a higher debt-to-equity ratio, while service industries have a lower D/E ratio.
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Quick ratio is another useful indicator. It shows if the company can meet its obligations without having to sell inventory.
The formula is:
(current assets−inventory) / current liabilities = quick ratio.
A higher quick ratio is a good sign, as it means that the company has strong liquidity. Conversely, a lower quick ratio indicates that the company may have to rely on inventory sales to pay its bills.
Net worth: how do assets and liabilities affect it?
Assets and liabilities can increase or decrease a company's net worth.
Here is the formula that ties these metrics:
Net worth = Total assets — Total liabilities.
According to the formula, an increase in assets and/or decrease in liability means an increase in net worth, while reducing the number of assets and/or increasing liabilities results in the net worth getting smaller.
What does a balance sheet not show?
A balance sheet is a powerful instrument for managing finances, but there are important things it does not show. For example, contingent liabilities — possible obligations that might arise in the future — usually do not find their way into balance sheets. These are lawsuits, guarantees, and product warranties. However, if there is a chance to estimate a potential liability, that can appear in a balance sheet. They also do not show goodwill and intellectual property.
