Balance Sheet
A balance sheet is a financial statement that summarises, at a particular point in time, the assets, liabilities, and equity of an individual, firm, or institution. It provides a snapshot of financial position, showing what is owned, what is owed, and the residual value attributable to the owners. The balance sheet is one of the fundamental financial statements, alongside the income statement and the cash flow statement.
Definition and the accounting identity
A balance sheet is built on the accounting identity:
- Assets = Liabilities + Equity
Assets are resources controlled by the entity that are expected to yield future economic benefits. They include cash, accounts receivable, inventory, property, plant, equipment, and intangible assets such as patents and goodwill. Assets are typically classified as current (expected to be converted to cash or used within a year) or non-current.
Liabilities are present obligations arising from past events that are expected to result in an outflow of resources. They include accounts payable, loans, bonds, and accrued expenses. Like assets, liabilities are classified as current or non-current.
Equity (also called net assets or shareholders' equity) is the residual interest in the assets after deducting liabilities. It represents the owners' claim on the entity and comprises contributed capital and retained earnings.
Because the identity must hold by construction, the two sides of the balance sheet always balance—hence the name.
The balance sheet for a firm
For a corporation, the balance sheet reports the firm's financial position as of a specific date. The asset side lists what the firm owns; the liability side lists what it owes; and the equity section shows the book value of shareholders' interest.
The balance sheet is closely related to other financial statements. The income statement reports revenues and expenses over a period, and the difference between them—net income—flows into retained earnings on the balance sheet. The cash flow statement explains changes in the cash balance, linking the income statement and the balance sheet.
Several key ratios are derived from the balance sheet. The current ratio (current assets divided by current liabilities) measures short-term liquidity. The debt-to-equity ratio measures financial leverage. Return on equity relates net income to shareholders' equity.
Limitations of the balance sheet
The balance sheet has important limitations. Assets are generally recorded at historical cost less depreciation, so book values may diverge substantially from market values, particularly for land, buildings, and brand value. Intangible assets generated internally, such as research and development and human capital, are typically not capitalised and therefore do not appear as assets. The balance sheet reflects a single point in time and may not be representative of the firm's position on other dates.
The balance sheet in banking
The balance sheet is particularly important for banks and other financial institutions, whose business consists of managing assets and liabilities. A bank's assets include loans, securities, and reserves; its liabilities include deposits and borrowed funds; and its equity provides a buffer against losses.
The structure of a bank's balance sheet gives rise to two characteristic risks. Liquidity risk arises because banks fund long-term, illiquid assets with short-term, liquid liabilities (deposits) that can be withdrawn on demand. Interest rate risk arises because a bank's assets and liabilities may reprice at different times.
The health of a bank's balance sheet is measured by its capital adequacy, the ratio of equity to risk-weighted assets. Regulatory frameworks, such as the Basel accords, set minimum capital requirements to ensure that banks can absorb losses without becoming insolvent.
The national balance sheet
The balance sheet concept extends to the economy as a whole. A country's international investment position is a balance sheet of its external assets and liabilities, showing whether it is a net creditor or net debtor to the rest of the world. The difference between a country's external assets and liabilities, together with other factors, influences its external vulnerability.
Governments also maintain balance sheets, though these are often complicated by the range of assets and liabilities they hold, including infrastructure, financial assets, pension obligations, and contingent liabilities such as guarantees. Measures of public sector net worth attempt to capture the overall position.
The balance sheet and financial crises
Balance sheet analysis is central to understanding financial crises. A balance sheet recession occurs when firms and households focus on reducing debt and repairing their balance sheets rather than on spending and investing, depressing aggregate demand even when interest rates are very low. The concept, associated with Richard Koo, has been used to explain the prolonged stagnation of the Japanese economy.
Similarly, currency mismatches on balance sheets—where an entity's liabilities are denominated in foreign currency while its assets are in domestic currency—make the entity vulnerable to depreciation, a factor that contributed to several emerging market crises in the 1990s and 2000s.