What is a balance sheet and why is it important?

A balance sheet is a versatile document that offers a snapshot of a company's or individual's finances at a given point in time.

Businesses can use balance sheets to develop plans for the future and present a picture of their financial health to investors or other outside entities. You can also generate a personal balance sheet to get a concise view of your assets and liabilities.

Here, CNBC Select explains what a balance sheet is, how to create one and how it can be useful to both companies and individuals.

• What is a balance sheet?
• How a balance sheet works
• Why balance sheets are important
• How to make a personal balance sheet
• FAQs
• Bottom line

A balance sheet, also known as a statement of net worth, is a summary of a company's financial status at a specific point in time. It presents all assets and liabilities, as well as any investments from shareholders. It is one of the three primary financial statements all companies are required to have by law, along with an income statement and a statement of cash flows.

Because it uses archival data, a balance sheet only presents a snapshot of a company's financial situation. While it's a critical tool, it can't guarantee future performance.

A balance sheet uses a formula that equates a company's assets with its liabilities plus its shareholder equity. The equation should always be in "balance," with the two sides equal.

Here's what each aspect of the balance sheet equation represents:

• Assets: Assets are resources with quantifiable value, such as cash, inventory or money the company is owed. They are often split into current assets — bank accounts, inventory and other things that could easily be converted into cash — and fixed assets — buildings, machinery, long-term loans to customers and other things that will stay on the books longer. (Intellectual property can also be included as a fixed asset.)
  
• Liabilities: Essentially the opposite of an asset, a liability is something the company owes, usually a sum of money. They are divided into short-term liabilities — like salaries, rent and money owed to other companies — and long-term liabilities , like mortgages, larger loans and long-term leases.
  
• Shareholder equity: This is a company's net worth — essentially what would be left if the business had to liquidate its assets and pay off all its debts. It most commonly takes the form of stocks and retained earnings (money the company earned but hasn't distributed to investors), but also includes any capital investments. Analysts and investors can use shareholder equity to judge a company's financial well-being.

While there can be nuances regarding the classification of certain assets or liabilities, a balance sheet is still a good way to determine a company's financial health at a given point in time.

In a corporation, a balance sheet lets stakeholders know if the business is solvent, meaning the value of its assets is higher than the total of its liabilities. It can also pinpoint areas where the company is underperforming.

Externally, a balance sheet lets potential investors, clients and other businesses know if a company is solvent. Did it borrow more money than it should have? Are its liabilities higher than the industry average? Is the available cash on hand higher or lower than normal?

While you'll most often hear about balance sheets in the context of business, they can also help individuals take stock of their finances and make informed purchasing and investing decisions.

You can also use a balance sheet to quickly determine several key financial measurements:

• The current ratio, the current assets divided by current liabilities, illustrates a company's ability to pay off debts over the next 12 months.

• A quick ratio indicates a company's ability to pay off debt right away. It's determined by dividing liquid assets (cash/cash equivalents + short-term investments + accounts receivable) by current liabilities. The quick ratio is often the same as the current ratio.
  
• There is also the debt-to-equity ratio, or "risk ratio." It's a company's total liabilities divided by its total equity. This metric reveals how much of a business is financed by debt. If a company is highly leveraged, it can make it hard to get additional financing.

The formula for a personal balance sheet is similar to one for a business, only without shareholder equity. Essentially, your net worth is equal to your assets minus your liabilities, or debts.

To create a personal balance sheet, start by collecting relevant financial records from your bank, investment companies and creditors. Using a personal finance app, such as You Need A Budget (YNAB), can be helpful during this kind of deep dive. YNAB syncs with your bank and investment accounts, allowing you to assign funds to different life categories to better help you visualize your finances.

Now, tally up your assets. This includes money in checking accounts, savings accounts and retirement funds, as well as your car or home (if you own them outright) and valuables like jewelry, art or collectibles.

Then work on identifying your liabilities, or outstanding debts. Common ones include mortgages, student loans, car payments and credit card bills.

Once you've listed both, subtract your liabilities from your assets. The resulting figure is your net worth.
If the amount is lower than you would like, or even negative, remember that this is just a snapshot of your current status.

You now have information that can help you address your financial situation.

For instance, if you see you've accumulated a substantial amount of credit card debt, you could consider applying for a balance transfer credit card like the Wells Fargo Reflect® Card, which has a 0% intro APR for 21 months from account opening on purchases and qualifying balance transfers (17.49%, 23.99%, or 28.24% variable APR thereafter). Balance transfers made within 120 days qualify for the intro rate, BT fee of 5%, min: $5.

If you kept up with payments, you could chip away at your debt without being buried under a high interest rate.

Businesses use balance sheets to indicate their financial standing. They can also be used by individuals or households to get a high-level view of their current wealth and identify areas for improvement.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every article is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of financial products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

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