What is a Balance Sheet?
If you are a Business Owner or Investor you are likely to come across the Balance Sheet multiple times in your life so it's important that you understand it well.
A Balance Sheet is a Financial Statement which gives the reader a 'snapshot' of the companies financial condition at a given point in time. It lists out what the company owns and what the company owes giving insights into the overall health of the business.
Why is it important?
The Balance Sheet is important because it helps users make decisions.
For Example, it helps Business Owners and Managers make better strategic decisions by answering questions such as -
- Is Inventory piling up?
- Are customers paying on time?
- Can the company take on more debt?
It helps Bankers and Investors make sound investing decisions by answering questions such as
- Is it viable to invest or lend to this company?
- Will this company be able to handle any rough times ahead?
- How is this company doing compared to it's competitors? etc.
Understanding the Balance Sheet
To fully understand a Balance Sheet - you must understand the 3 elements that make up a Balance Sheet.
The 3 Elements of a Balance Sheet
Assets are the resources that a company owns. These resources are expected to provide future economic value to the business. Assets of a business include cash, accounts receivable, inventory, vehicles, machinery and goodwill amongst many others. To learn more about Assets, check out our post here.
Everybody owes something to someone and a Business is no different. Liabilities show what all the obligations of a company are and all that the company owes. This includes all Financing or borrowing, all money owed to suppliers etc. To dig deeper into Liabilities, check out our post here.
The Equity Elements of the Balance Sheet shows the contribution made by the Business owners into the Business and any past profits retained in the Business. To learn more about Equity, check out our post here.
Don't assume you know more then you actually do!
It's important for you to understand ALL the 3 Elements well before you move on as they are integral to a proper understanding of the Balance Sheet.
Balance Sheet Formats
The 3 Elements - Assets, Liabilities and Equity are listed as SEPARATE SECTIONS in a Balance Sheet and come in 2 basic styles - The Account Format and The Report Format.
1. The Account Format
The Account Format is a horizontal presentation of the 3 elements.
Long Term Assets
TOTAL LIABILITIES + OWNERS EQUITY
2. The Report Format
The Report Format is a vertical presentation of the 3 Elements.
Long - Term Assets
Long Term Liabilities
TOTAL LIABILITIES + SHAREHOLDERS EQUITY
The Accounting Equation
The Accounting Equation shows how each of the above 3 Elements (The Assets, Liabilities and Owners Equity) relate to one another.
To understand how the 3 Elements fit together - you need to become familiar with what is called "THE ACCOUNTING EQUATION"
The Accounting Equation formula states:
ASSETS = LIABILITIES + OWNERS EQUITY
This formula ties the 3 elements - Assets, Liabilities and Equity together.
But what does this really mean?
It means that ALL Assets purchased in a Business have been purchased in one of two ways which are - By financing of some sort (Liabilities) or Owner Funds (Equity).
That's why Assets = Liabilities + Owners Equity
Pretty simple right!
Once you understand the Accounting Equation, understanding the Balance Sheet of any company is a snap!
Just be aware of the simple concept -
The Assets of a Business are the Elements that produce Revenue for the firm, and the Balance Sheet gives you a big picture view of the Assets AND a big picture view of the Liabilities and Owners Funds (Equity) used to purchase those assets.
Now how's that for Superpower Document!!!
Putting it all together - A Sample Balance Sheet
TOTAL CURRENT ASSETS
TOTAL CURRENT LIABILITIES
Plant and Machinery
TOTAL LONG TERM LIABILITIES
TOTAL FIXED ASSETS
TOTAL LIABILITIES + EQUITY
So, what does the Balance Sheet tell you about the Business?
Well, quite a lot!
Let's start with the Assets side
- The Assets Side of the Balance Sheet shows you the Cash the company holds as of Dec 31, 20xx which is USD 1.8 Million.
- The Accounts Receivable Balance of USD 1.0M shows that the company sells goods on Credit.
- The Inventory balance of USD 1.5M shows the Inventory held by the company (at cost). This Inventory can be expected to be sold and become Revenue in the coming months.
- The Prepaid Expense Row of USD 300,000 show Expenses paid in Advance. Prepaid Expenses often include Rent, Insurance, Subscriptions amongst other expenses paid in advance.
Now, let's understand the Liabilities
- An Accounts Payable Balance of USD 600K shows that the company has purchased goods on Credit.
- An Accrued Expense Balance of USD 700,000 shows that the company has incurred some liabilities which are due to be paid within the next 12 months.
- The Short Term Bank Overdraft and Long Term Bank Loans balance shows that the company has borrowed money from banks. Debt balances are of particular interest to readers of Financial Statements since they reveal significant details of the company. It is upto the reader to investigate further if the money borrowed was used to Finance Growth and Expansion or was it borrowed since the company is having difficulty staying afloat.
Finally, we come to the Equity Section where we see...
- The Capital Category shows that owners have input USD 1,000,000 into the business in return for ownership (shareholding) in the company.
- Retained Earnings of USD 2.2M mean that the Business 'Retained' (Kept) USD 2.2M in Profits which have been accumulated over the years,
As you start reading the Balance Sheet of Larger corporations, you will see that they don't used very large numbers such as 5,000,000,000 or exact matches such as 5,642,749,888.45. Companies prefer to round off numbers to make the Balance Sheet easier to read for users. Details of the rounding off of these numbers is usually mentioned on top of the Balance Sheet.
Every set of Financial Statements is accompanied by a "Notes to Financial Statements" section.
The Notes show more detail on every aspect defined above.
Ironically, the notes of an annual report often take up more room and contain much more detail then the Financial Statements themselves.
Once you get more advanced in reading a Balance Sheet you will be able to perform what is called a "Ratio Analysis" where you can calculate Ratios such as Current ratio, Quick Ratio and Debt to Equity Ratio which gives you deep insights into the performance of the company and become a better decision maker with regards to the business.
To summarize, the Balance Sheet is a 'snapshot' of a company in time.
The Balance Sheet consists of 3 Elements - The Assets, Liabilities and Owners Equity.
The Foundation of the Balance Sheet is the Accounting Equation which is Assets = Liabilities + Owners Equity
The Balance Sheet comes in 3 formats - The Account Format, the Report Format and the Working Capital Format.
The 3 Main Financial Statements are The Balance Sheet, The Income Statement and The Cash Flow Statement.
If you are new to accounting the next thing I would read about would be the Income Statement or the Cash Flow Statement.
If you want to learn accounting with a dash of humor and fun, check out our video course.
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Tax and accounting rules and information change regularly. Therefore, the information available via this website and courses should not be considered current, complete or exhaustive, nor should you rely on such information for a particular course of conduct for an accounting or tax scenario. While the concepts discussed herein are intended to help business owners understand general accounting concepts, always speak with a CPA regarding your particular financial situation. The answer to certain tax and accounting issues is often highly dependent on the fact situation presented and your overall financial status.