Understanding Your Balance Sheet
In other words:
BASIC BALANCE SHEET ACCOUNTING EQUATION
assets = liabilities + shareholders’ equity
Principle: A company’s assets must be equal to the sum of its liabilities and shareholders’ equity.
A Balance Sheet portrays the financial position of a company by showing what the company owns at a specific point-in-time, like a snapshot. The point-in-time is the date stated in the heading of the Balance Sheet and every Balance Sheet is divided into the three sections it represents:
- Assets
- Liabilities
- Shareholder’s Equity
By way of illustration, let’s look at some sample Balance Sheets:
Balance Sheets can be laid-out either horizontally or vertically.
A Horizontal Balance Sheet
In a horizontal set up, the monetary value of left side is equal to the monetary value of right side.
- On the left side of the balance sheet, companies list their assets.
- On the right side, they list their liabilities and shareholders’ equity.
In a vertical set up, the monetary value of the top portion is equal to the monetary value of the bottom portion.
In the top portion of the balance sheet, companies list their assets.
In the bottom portion, companies list their liabilities and shareholders’ equity.
As you can see, the Balance Sheet is divided into the three main sections and that it balances, meaning
Total Assets = Total Liabilities + Stockholders’ Equity
Whether it is laid out horizontally or vertically, it still balances.
Let’s take a closer look at each section and this equation.
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Assets of a Balance Sheet Defined:
Assets are defined as those things that a company owns and that have value. Assets might include physical property like plants, cars, trucks, machines, and inventory. It may also include intangible things (things that do not exist in a physical sense, but which nevertheless have monetary value), such as trademarks and patents.
Cash, in and of itself, is also considered an asset, as are Accounts Receivable (the money due in from customers) securities and investments and any other item of value.
Specifically, businesses use assets, as shown on a balance sheet, in their day-to-day operations for earning money. This use typically means either a business can sell these assets, or it can use them to make products for sale, or to render services. As in the illustration, assets can be divided into current and non-current assets.
Liquidity Explained
The difference is how “liquid” or readily-available the asset is to use. For example, selling a security or investment for cash makes the asset liquid and “Current”. Non-Current usually means physical assets such as buildings or equipment, which have value, maybe considerable value, but are difficult to sell or turn into ready cash.
Intangible Assets
Intangible assets such as trademarks, patents, goodwill, etc. are difficult to set a specific value but are definitely part of the overall value of a company, Unfortunately, these cannot be transferred into ready cash.
Any item having no monetary value is irrelevant to the financial state of a company at a point in time and is therefore not taken into consideration on a Balance Sheet.
Normally, if a non-monetary thing has a potential effect on items on a balance sheet, then this information is listed in the footnotes or documentation that accompanies the balance sheet or with any other financial statements and reports.
Generally, we list assets in order of liquidity, or how quickly they will be converted into cash.
Therefore, a breakdown of assets into the categories of current assets (those that can be converted to cash quickly) and long-term assets (which take more time to convert to cash) is necessary to place them on balance sheet at proper place. Current assets and long-term assets typically are subtotaled in the asset list.
As you see illustrated below:
Current assets are things a company expects to convert to cash within one period. Normally, this period is one year. A good example of current assets is inventory.
Most companies expect to sell their inventory for cash within one year. However, there may be situations where businesses stock nonperishable inventories as a part of their business strategy; in expectation that the inventory will maintain or increase in value in the future.
Noncurrent assets are things a company does not expect to convert to cash within one year or that would take longer than one year to sell. This type of assets includes fixed assets, and the assets used to operate the business which are not available for sale, such as cars, office furniture, buildings and other property.
Liabilities Defined:
Liabilities can be thought of as money that a company owes and is obliged to pay to others to acquire assets and to run a business. Liabilities include all kinds of obligations, such as money borrowed, rent for use of a building, money owed to suppliers, environmental cleanup costs, payroll, as well as, taxes owed to the government. Liabilities may also include obligations to provide goods or services to customers in the future.
Therefore, to keep things in balance, if one thing on your balance sheet is an asset or a positive item, then its opposite is a liability. (Equity is a special type of liability that we cover later.)
From an economic perspective, each dollar of assets must be “funded” by a dollar of liabilities or equity. This principle is what we described earlier as “in balance” and is the standard way accountants and bookkeepers note a transaction, to verify that the accounts balance. (You can think of this as you would think of a quid pro quo or “give & take” transaction.)
For example, if you purchase something on credit, you receive it from the seller or manufacturer and it becomes an asset to the business; but you also need to convey the debt, or short-term liability of the money that went to the seller or manufacturer. For every amount of value that you receive, you in turn, give an amount of value as payment, keeping the company’s books in balance.
Current versus Long-term Liabilities
Liabilities can also be divided into two categories based on their due date: current liabilities and long-term liabilities. We list them on balance sheet based on their due dates, just as we list assets in order of liquidity. Current liabilities are obligations a company that it expects to pay off within the year. On the asset side, their counterparts are current assets. Long-term liabilities are obligations due more than one year out. On the asset side, their counterparts are the fixed assets.
Capital or Shareholders’ Equity
Capital or shareholders’ equity is the amount the owners invested in the company’s stock, plus or minus the company’s earnings or losses since the inception of the business.
A company may or may not distribute its earnings. Business circumstance and liquidity (cash) needs dictate the decision to distribute earnings. When companies distribute earnings instead of retaining them, these distributions are called dividends. A full distribution of earnings seldom occurs. Generally, only a part of the earnings becomes a dividend.
In summary, one must strictly think of a balance like a snapshot. It is not like a movie that records the happenings of a company from the start to the end of a period; it only shows a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the reporting period. It does not show the flow into and out of the company’s accounts during the reported period. For this information, businesses use Income Statements and Cash Flow Statements.
Fundamentals of Financial Statements, 4 Part Series