Fundamental Balance Sheet Equation
The fundamental accounting equation states that at all times, a company’s assets must be equal to the sum of its liabilities and shareholders’ equity.
Assets = Liabilities + Shareholders’ Equity
The three components of the equation will now be described in further detail in the following sections.
1. Assets Section of Balance Sheet
Assets describe resources with economic value that can be sold for money or have the potential to provide monetary benefits someday in the future.
The assets section is ordered in terms of liquidity, i.e. line items are ranked by how quickly the asset can be liquidated and turned into cash on hand.
On the balance sheet, a company’s assets are separated into two distinct sections:
- Current Assets → The assets that can or are expected to be converted into cash within one year.
- Non-Current Assets → The long-term assets that are expected to provide economic benefits to the company in excess of one year.
While current assets can be converted into cash within a year, attempting to liquidate non-current assets (PP&E) can be a time-consuming process where substantial discounts are often necessary to be able to find a suitable buyer in the market.
The most common current assets are defined in the table below.
|Cash and Cash Equivalents
- The starting line item for practically all companies, cash and other highly liquid cash-like investments, such as commercial paper and certificate of deposits (CDs), are included here.
- Marketable securities are short-term debt or equity securities owned by a company that can be liquidated to cash relatively quickly (and can be treated as a cash equivalent for modeling purposes).
|Accounts Receivable (A/R)
- Accounts receivable represents the unfulfilled payments owed to a company by its customers for products or services already delivered to them (and thus “earned”), yet the customer paid on credit, i.e. an “IOU” from customers.
- Inventories refer to the material used to produce the end product, such as raw materials, work-in-progress (WIP), and finished goods that are marketable and waiting to be sold.
- Prepaid expenses describe the early payments issued in advance for goods and services that will not be provided until a later date, e.g. utilities, insurance, and rent.
The next section consists of non-current assets, which are described in the table below.
|Property, Plant and Equipment (PP&E)
- PP&E, or fixed assets, are the long-term investments that are core to a company’s revenue model, such as buildings, machinery, tools, and vehicles.
- Intangible assets refer to the non-physical assets belonging to a company such as patents, trademarks, intellectual property (IP), and customer lists — which are not recognized on the balance sheet until an acquisition occurs.
- Goodwill is an intangible asset created to capture the excess of the purchase price over the fair market value (FMV) of an acquired asset, i.e. the premium paid.
2. Liabilities Section of Balance Sheet
Similar to the order in which assets are displayed, liabilities are listed in terms of how near-term the cash outflow date is, i.e. liabilities coming due sooner are listed at the top.
Liabilities are also separated into two parts on the basis of their maturity date:
- Current Liabilities → The liabilities that are expected to be paid within one year.
- Non-Current Liabilities → The long-term liabilities that are not expected to be paid for at least one year.
The most frequent current liabilities that appear on the balance sheet are the following:
|Accounts Payable (A/P)
- Accounts payable represent the unpaid bills owed to suppliers and vendors for services or products already received, yet were paid for on credit by the company.
- Accrued expenses are the expenses incurred by a company such as employee compensation or utilities, however, the payment has not yet been issued — most often because the invoice is still waiting to be processed.
- Short-term debt securities have maturity dates that are coming due within the next twelve months (including the current portion of long-term debt).
The most common non-current liabilities include:
- Long-term debt represents any debt obligations with maturity dates that do not come due for at least one year, i.e. maturity exceeds twelve months.
- Deferred revenue, i.e. “unearned revenue”, represents customer payments received by a company in advance for goods or services not yet delivered.
- Deferred taxes are created from temporary timing discrepancies between the tax expense recorded under GAAP and the actual taxes paid — but the temporary timing differences between book and tax accounting eventually unwind over time to zero.
- Lease obligations are contractual agreements that provide the company with the right to lease a fixed asset for an agreed-upon duration in exchange for regular payments.
3. Shareholders Equity Section of Balance Sheet
The second source of funding, other than liabilities, is shareholders’ equity, which consists of the following line items.
- Common stock represents a share of ownership in a company and can be issued when raising capital from outside investors in exchange for equity.
|Additional Paid-In Capital (APIC)
- APIC captures the amount received in excess of the par value from the sale of preferred or common stock.
- Preferred stock is a form of equity capital often considered a hybrid investment, as it blends features of common equity and debt.
- Treasury stock is a contra-equity account that stems from a company repurchasing shares that were previously issued but were repurchased by the company as part of a continuous or one-time share buyback (and those shares are no longer available to be traded in the open markets).
|Retained Earnings (or Accumulated Deficit)
- Retained earnings represent the cumulative amount of earnings kept by a company to date since the date of formation, i.e. the remaining profits not issued as dividends to compensate shareholders.
|Other Comprehensive Income (OCI)
- OCI is more of a “catch-all” line item for miscellaneous items such as foreign currency translation adjustments (FX) and unrealized gains or losses on available-for-sale securities.
Sample Balance Sheet Example: Apple Inc. (NASDAQ: AAPL)
The balance sheet of the global consumer electronics and software company, Apple (AAPL), for the fiscal year ending 2021 is shown below.
Apple Balance Sheet (Source: 10-K)
Balance Sheet Financial Analysis Ratios
While all of the financial statements are closely intertwined and necessary to understand the true financial health of a company, the balance sheet tends to be particularly useful for conducting ratio analysis.
More specifically, the following are some of the most common ratio types used in practice to evaluate companies:
- Returns-Based Metrics → In conjunction with the income statement, returns-based ratios such as the return on invested capital (ROIC) can be utilized to determine how effectively a company’s management team can allocate its capital into profitable investments and projects. The companies with a sustainable economic moat tend to exhibit outsized returns relative to their competitors, which stems from sound judgment by management with regard to capital allocation decisions and strategic decisions such as geographic expansion, as well as the timely avoidance of poorly invested capital.
- Efficiency Ratios → Efficiency ratios, or “turnover” ratios, reflect the efficiency at which management can utilize the company’s asset base, investor capital, etc. All else being equal, a company with higher efficiency ratios relative to its peers should be more cost-effective and thereby have higher profit margins (and more capital to reinvest into operations or future growth).
- Liquidity and Solvency Ratios → Liquidity ratios are more of a risk measure, with most of the metrics comparing a company’s asset base to its liabilities. In short, the more assets that belong to a company, especially liquid assets like cash sitting on the company’s balance sheet, the lower the liquidity risk of the company — both on a short-term (e.g. current ratio, quick ratio) and long-term basis (i.e. solvency ratios).
- Leverage Ratios → Leverage ratios, much like liquidity ratios, are meant to ensure that the company can continue to operate as a “going concern”, i.e. credit risk. The over-reliance on debt is by far the most common cause of financial distress (and filing for bankruptcy) among corporations. The capital structure of each company is a critical decision that management must adjust accordingly to avoid the risk of defaulting on any financial obligations and being forced into a reorganization (or straight liquidation) by its creditors. For example, a company’s debt balance can be compared to its total capitalization (i.e. debt + equity) to gauge the company’s reliance on debt financing.
Balance Sheet Calculator — Excel Template
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
How to Create Balance Sheet in Excel (Step-by-Step)
Suppose we’re building a 3-statement model for Apple (NASDAQ: AAPL) and are currently at the step of entering the company’s historical balance sheet data.
Using the screenshot from earlier, we’ll enter Apple’s historical balance sheet into Excel.
To abide by general financial modeling best practices, the hardcoded inputs are entered in blue font, while the calculations (i.e. the ending total for each section) are in black font.
But rather than copying every single data point in the same format as reported by Apple in their public filings, discretionary adjustments that we deem appropriate must be made for modeling purposes.
- Marketable Securities → Cash and Cash Equivalents: For instance, marketable securities are consolidated into the cash and cash equivalents line item because the underlying drivers are identical.
- Short-Term Debt → Long-Term Debt: The short-term portion of Apple’s long-term debt was also consolidated as one line item since the debt schedule roll-forward is the same.
However, that does NOT mean that all similar items should be combined, as seen in the case of Apple’s commercial paper.
Commercial paper is a form of short-term debt with a specific purpose that is different from long-term debt. In fact, the 3-statement model of Apple we build in our Financial Statement Modeling (FSM) course treats the commercial paper like a revolving credit facility (i.e. the “revolver”).
Once all the historical data of Apple is entered with the proper adjustments to make our financial model more streamlined, we’ll input the rest of Apple’s historical data.
Note that in our model, the “Total Assets” and “Total Liabilities” line items include the values of the “Total Current Assets” and “Total Current Liabilities”, respectively. In other instances, it is common to see the two separated into “Current” and “Non-Current”.
Upon completion, we must ensure the fundamental accounting equation holds true by subtracting total assets from the sum of the total liabilities and shareholders’ equity, which comes out to zero and confirms our balance sheet is indeed “balanced”.