When you hear the term “statement of financial position,” you might picture rows of numbers and financial jargon that feel distant or complex. But at its core, it’s a tool that offers insights into how businesses function and thrive.
A balance sheet is an essential window into a company’s well-being, revealing its strengths, vulnerabilities, and growth potential. Understanding a balance sheet is not just a skill for accountants; it’s a critical lens through which investors, entrepreneurs, and everyday individuals can assess the financial stability of any enterprise.
So, what is the statement of financial position, and why is it important?
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What is the Statement of Financial Position?
The Statement of Financial Position is a financial statement that provides a snapshot of an entity’s financial health at a point in time. It gives investors and other stakeholders information on what the entity owns (assets), what it owes (liabilities), and the residual interest to its owners (equity).
For listed companies (any company traded on a stock exchange), statements of financial position are prepared and published to the public at the end of every quarter and financial year. However, due to differences in financial reporting standards, companies will refer to the statement by a different name.
European companies follow the International Financial Reporting Standards (IFRS) and use the term ‘Statement of Financial Position.’ American companies follow the Generally Accepted Accounting Principles (GAAP) and use the term ‘Balance Sheet.’ The statements are headed up slightly differently as well.
As per International Financial Reporting Standards (IFRS), Statements of Financial Position are headed up in the following way:
Entity Name
Statement of Financial Position
As at [date of financial year end]
As per Generally Accepted Accounting Principles (GAAP), Balance Sheets are headed up in the following way:
Entity Name
Balance Sheet
Companies often present the statement as the ‘Consolidated Statement of Financial Position’ or ‘Consolidated Balance Sheet’. This means the information presented is for a group of businesses controlled by a central entity – not financials for a single entity.
Why is the Statement of Financial Position Important?
As a primary financial statement, the statement of financial position is essential due to several factors. Its importance can be understood through the following points.
Provides insight into financial health
The statement of financial position shows a company’s short-term financial health. By comparing current assets against current liabilities, investors and other stakeholders can determine if a company can meet its short-term obligations as they fall due.
Similarly, the statement shows a company’s long-term financial health. By comparing total assets against total liabilities, investors and other stakeholders can assess a company’s long-term viability.
Provides insight into a company’s sources of funding and leverage
Companies have two sources of funding – debt and equity – both appearing on the statement of financial position. Therefore, a company’s leverage (the amount of debt used to fund the company’s operations relative to equity) can be deduced.
A highly leveraged company (one with high amounts of debt relative to equity) might be deemed riskier as it relies heavily on borrowing. Being highly leveraged also has negative implications concerning shareholder rewards. Most prudent companies prioritise paying down debt over distributing additional profits as dividends to shareholders.
Provides insight into a company’s borrowing capacity
Lenders often use a company’s statement of financial position to determine its creditworthiness (if the company is worth lending to). A strong statement of financial position makes it easier to secure loans and other forms of financing with favourable credit terms, like lower interest rates.
On the contrary, a company with a questionable statement of financial position will find it harder to access lending. If the company does access lending, it may face higher borrowing costs due to the higher perceived risk.
Structure of the Statement of Financial Position
The structure of every statement of financial position is based on a simple equation: the accounting equation. This equation states that a company’s total assets are equal to the sum of its liabilities and equity:
Assets = Liabilities + Equity
Or that a company’s net assets (assets – liabilities) is equal to total equity:
Assets – Liabilities = Equity
Because of this, the statement of financial position is divided into three sections, organised to maintain the balance of this fundamental equation.
Here’s how each section is typically structured.
Assets
Assets are economic resources owned by an entity that can generate future benefits. They are classed as current or non-current based on liquidity (how fast they can be converted to cash).
Current Assets – assets expected to be converted to cash or used up within a year. Common examples include cash and cash equivalents, accounts receivables and inventory.
Non-Current Assets – assets not expected to be converted to cash or used up within a year. Common examples include land, buildings and machinery.
Total Assets – the sum of current and non-current assets.
Liabilities
Liabilities are obligations of an entity to transfer an economic resource that can produce future benefits. They are classed as current or non-current based on maturity (when the obligation must be settled).
Current Liabilities – liabilities expected to be settled within a year. Common examples include short-term borrowings and accounts payable.
Non-Current Liabilities – liabilities not expected to be settled within a year. Common examples include long-term borrowings and capital leases.
Total Liabilities – the sum of current and non-current liabilities.
Equity
Equity is the residual interest in a company’s assets after deducting all liabilities. It represents what shareholders would receive if the company sold all its assets and settled all liabilities.
The equity section of a statement of financial position includes the following.
Share Capital (common stock) – the total cash stated at par value (the original value of the shares when they were first sold) that shareholders have contributed to the company. Share capital is used by companies that follow IFRS (International Financial Reporting Standards), and common stock by companies that follow GAAP (Generally Accepted Accounting Principles).
Share Premium (additional paid-in capital) – the surplus cash a company receives for issuing shares above par value. Share premium is used by companies that follow IFRS, and additional paid-in capital by companies that follow GAAP.
Retained Earnings – the portion of a company’s accumulated profits that weren’t paid to shareholders as dividends.
More accounts are included in the equity section, but these vary from company to company. Some examples include treasury stock and other accumulated gain/(loss).
Total Shareholder’s Equity – the sum of all accounts in the equity section.
Statement of Financial Position Examples
The following examples show how a statement of financial position would be presented under the International Financial Reporting Standards and Generally Accepted Accounting Principles.
Example 1: IFRS Statement of Financial Position
Companies that follow the International Financial Reporting Standards often present their assets section in the order of permanence. The assets that take the longest to be used up or converted to cash are listed first.
These companies also use the net asset approach when presenting their statements of financial position. This approach rearranges the accounting equation from assets = liabilities + equity to assets – liabilities = equity. The equation remains balanced.
The net assets figure is found by subtracting total liabilities from total assets. In the above example, net assets and total equity equate to £406 million. The adjusted accounting equation balances (assets – liabilities = equity).
Reverting to the original equation (assets = liabilities + equity), total assets equal £687 million, and total liabilities and equity equal £687 million (281 million + 406 million) – the equation still balances.
Example 2: GAAP Balance Sheet
Companies that follow Generally Accepted Accounting Principles often present their assets section in the order of liquidity. The assets that take the least time to be converted to cash or used up are listed first.
The balance sheet is presented using the original accounting equation with the associated GAAP terminologies.
Total assets equal total liabilities plus total equity – the accounting equation balances.
Section Summary
Regardless of the difference in terminologies and approaches, the statement of financial position must always balance. Net assets must equal the sum of equity (assets – liabilities = equity), or total assets must equal the sum of liabilities and equity (assets = liabilities + equity).
If these equations don’t balance, there are errors in the financial statements.
How Investors Use the Statement of Financial Position
The statement of financial position provides crucial information on a company’s financial health and leverage. But how do investors and other stakeholders find these out?
Several financial ratios can be calculated from the statement of financial position, including the following.
Current Ratio
The current ratio measures an entity’s ability to cover its short-term obligations as they fall due. From its name, the metric compares an entity’s current assets and current liabilities and is expressed as a ratio (e.g., 2:1 or two to one).
The first number in the ratio represents current assets, and the second represents the company’s current liabilities.
The current ratio formula is as follows.
Current Ratio = Current Assets/Current Liabilities
Current Ratio Interpretation
A current ratio above 1 suggests a company can cover its short-term obligations, indicating a healthy short-term financial state. A 2:1 current ratio means the company has two times more current assets (e.g. £100,000) than current liabilities (e.g. £50,000).
A current ratio below 1 suggests that a company may have issues covering its current liabilities as they fall due, as it doesn’t have enough current assets to cover them. A 0.5:1 current ratio means the company has two times more current liabilities (e.g. £100,000) than current assets (e.g. £50,000).
Debt-to-Assets
The debt-to-asset metric measures the percentage of a company’s total assets financed by debt. It tells investors the proportion of assets funded by borrowing versus owner’s contributions (equity).
The debt-to-assets formula is as follows.
Debt-to-Assets = Total Liabilities/Total Assets
Debt-to-Assets Interpretation
A 0.5 (or 50%) debt-to-asset ratio means half of the company’s assets are financed by debt and the other half by equity.
A higher debt-to-asset ratio means the company relies more on debt to finance its assets, which can increase long-term financial risk. Debt can become a burden, especially when it’s too much and poorly managed.
A lower debt-to-asset ratio indicates that a company relies less on debt and is potentially more financially stable.
Debt-to-Equity
The debt-to-equity ratio measures how much debt a company uses to finance its operations versus equity. It gives investors and other stakeholders an insight into the company’s financial leverage and overall risk.
The debt-to-equity ratio formula is as follows.
Debt-to-Equity = Total Liabilities/Shareholder’s Equity
Debt-to-Equity Interpretation
A debt-to-equity ratio of 1 (or 100%) indicates that a company uses equal amounts of debt and equity to fund its operations. In other words, for every £1 of equity used to fund its business, a company uses £1 of debt.
A higher debt-to-equity ratio indicates that a company relies more on debt versus equity to finance its operations. For example, a debt-to-equity ratio of 2 (or 200%) means that for every £1 of equity, a company uses £2 of debt to finance its operations.
On the other hand, a lower debt-to-equity ratio indicates that a company relies more on equity to fund its operations, implying lower risk. A debt-to-equity ratio of 0.5 (or 50%) means that for every £1 of equity, a company uses £0.50 of debt to finance its operations.
Summary
The statement of financial position, commonly known as the balance sheet, is an essential financial statement that offers a clear view of a company’s financial standing at a specific point in time. Presenting assets, liabilities, and equity gives stakeholders vital insights into a company’s short-term and long-term health and stability.
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