Understanding the Balance Sheet for Beginners
One of the main financial reports of a business is called a balance sheet or statement of financial position. The balance sheet is simply a snapshot or summary of a company’s financial at a specific time. The balance sheet is the only financial statement that applies to a single point in a year. This allows entities like creditors to see what a company currently owns and owes.
There are three components that make up the balance sheet statement; assets, liabilities and owner’s (shareholder’s) equity.
Assets (has) = Liabilities (owes) + Shareholders Equity (worth)
Staying true to its title, the balance sheet must…balance out. This means that the total assets should equal liabilities plus owner’s equity. If you add an asset to the equation, you must add a liability or increase owner’s equity at the same time.
Balance Sheet Example
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Understanding Assets on a Balance Sheet
Simply put, assets are what a company has including cash, stock or inventory, buildings, machinery, etc. Assets on a balance sheet are shown according to their liquidity. The most liquid asset is shown first, which is cash and least liquid is last, usually fixed assets.
Current assets are assets that are anticipated to be converted to cash within twelve months from the date of the transaction. Current assets are listed on the balance sheet in descending order of liquidity;
- Cash – Cash is the most liquid asset; this includes bank deposits and petty cash. All cash, and any transaction on the balance sheet, must be converted to US dollars (USD).
- Accounts Receivable – Is the money owed to a business by its customer because they have provided a service or shipped out a product. Generally, payments terms are 30 or 60 days but shorter terms have been set due to the economy.
- Inventory – Is a finished product ready for sale. In addition, the materials used to make the product is considered inventory. There are three types of inventory; raw materials, work-in-process and finished good inventory. Raw material inventory are materials that are in stock and will be used in a product but haven’t thus far. Work-in-process (WIP) inventory is partially finished products in the production cycle. Finished good inventory is completed products ready to be sold to a customer.
- Prepaid Expenses – are payments that have already been paid out but service or product(s) haven’t been received yet. Examples of prepaid expenses are insurance premiums, salary advances and utility deposits.
Other Assets (non-current assets) – Is a category when assets cannot be properly labeled as a current or fixed asset; this includes intangible assets such as a patent.
Fixed Assets – These assets are the least liquid and generally the largest. These include land, building, equipment, furniture, vehicles, office equipment, computers and material handling machinery. These assets are not intended to be used towards a sale. They are reported on a balance sheet at their original purchase price or less the depreciation (decline in useful value due to wear and tear).
Accumulated Depreciation – Is the sum of all depreciation charges taken since the asset was acquired.
Net Fixed Assets – Is the total of the purchase price of fixed assets less the depreciation charges taken over the years.
Understanding Liabilities on a Balance Sheet
Liabilities are a company’s legal obligations that arise during the course of business operations. Liabilities are settled through the transfer of economic benefits such as money, goods or services. They include money owed to lenders, suppliers, employees, etc. Liabilities are categorized on the balance sheet by to whom the debt is owed and whether the debt is short-term (within 1 year) or long-term.
Current liabilities are debts that must be settled within the fiscal year or the operating cycle, whichever period is longer. Current liabilities are shown on a balance sheet depending on whom the debt is owed.
- Accounts Payable – are debts owed to a business or supplier that are purchased on credit and must be paid within 1 year. If a business does not pay cash for an item or service, this will be recorded as short-term money owed, accounts payable.
- Accrued Expenses – are monetary obligations that is not paid immediately to a entity.
- Notes Payable – Is created when a company signs a note for the purpose of borrowing money or extending its payment period with a bank or creditor.
- Current Portion of Debt – Is the amount due within 12 months for a long-term debt such as a mortgage on a building
- Income Taxes Payable – Income taxes that a company owes the government for a percentage of profit. Typically taxes are owed every quarter.
Long-term debt – Is a loan with an overall term of more than 12 months from the date of the balance sheet.
Understanding Shareholder’s Equity
Shareholder’s Equity (also known as net worth or book value) is the total assets minus the liabilities (current + long-term). Shareholder’s equity are made up of two components:
- Capital Stock – the original investment the owner(s) contributed towards the company.
- Retained Earnings – All earnings of the company that have been retained and has not been paid out as dividends.
Capital Stock is the number of shares authorized that are issued by a company’s charter; includes both common stock and preferred stock.
Retained Earnings – is all of the company’s profits that have not been paid out to the shareholders as dividends. Dividends are paid from the retained earnings. Accumulated deficit is when a company has not made a profit which will result in a negative retained earnings.
Owner’s (Shareholder’s) Equity is the sum of the investment made in the stock of the company plus any net profits minus dividends that has been paid out to shareholders.
- A decrease in owner’s equity happens when there is either a loss or it pays dividends.
- An increase in owner’s equity occurs when the company makes a profit or sells new stock to investors.