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The Balance Sheet

Posted by Seth Elliott On October - 7 - 2010

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The balance sheet is a snapshot of the financial condition of a company. Essentially, it reveals – at a set moment in time – what the company owns or possesses (assets), what the company owes (liabilities) and what the company is worth “on paper” (equity). Balance sheet items can be evaluated in various ways, but the core use of the balance sheet as a whole is to evaluate the financial health of a company.

As I’ve just implied, the balance sheet consists of three broad categories: Assets, Liabilities and (Shareholders’) Equity. We will examine each of these categories directly shortly, however, you should know that one of the most “famous” accounting equations comes from the balance sheet:

Assets = Liabilities + Equity

This tells us that certain elements of the balance sheet must remain in equilibrium (“balance” – thus the name). Failure to meet this test would mean that the balance sheet itself is not “in balance” – therefore invalid. Of course, this equation can be rearranged as desired, including:

Assets-Liabilities = Equity

Liabilities = Assets – Equity (though this is rarely used)

Let’s examine the primary categories of the Balance Sheet: Assets, Liabilities and Equity.

Assets are actual “things” that you own in your business such as cash, capital equipment, money due to you etc. Assets basically describe resources of your enterprise that are anticipated to provide some future benefit for your firm – primarily an increase in cash inflows or decrease in cash outflows. Assets are not always tangible in nature (we will discuss this in more detail in future posts), but they always represent some value that will inure to your company. Assets are generally categorized between Current and Noncurrent Assets.

Current Assets are those deemed most liquid – essentially assets that can be sold (turned into cash) or consumed (utilized) within 12 months of the date of the Balance Sheet. These include items like cash, marketable securities, current accounts receivable, inventory, etc.

Noncurrent Assets are those items that are unlikely to be consumed (used) or liquidated (converted into cash) in less than one year. These often include property, capital equipment and various intangible assets.

On the other side of the balance sheet, so to speak, are Liabilities. As the name suggests, Liabilities are obligations of your business. These represent debts of the firm or monies that are owed (or reserved) to others. Obligations can include borrowed funds, bills you have yet to pay, taxes due but unpaid, etc. Like Assets, Liabilities are usually categorized between Current and Noncurrent Liabilities.

Current Liabilities represent those obligations that a company is required to discharge within 12 months. These usually include accounts payable, short term debt, the current portion of any long term debt, etc.

Conversely, Noncurrent liabilities are those obligations that need not be discharged for more than 12 months. In most cases, this refers to long term debt instruments.

Finally, there is Equity. Equity is traditionally referred to as Shareholders’ Equity – sometimes Owners’ Equity. For ease of use, many simply reference Equity. Equity is the calculated “book value” of the company. Equity is simply the difference between assets and liabilities. In other words, this is what would be “left over” after a company liquidates everything it owns and then pays off everything it owes. Equity is equivalent to personal net worth.

Equity is generally broken down into two components: Paid-In Capital and Retained Earnings.

Paid-In Capital represents funds that have been invested directly into the business by the shareholders of the firm. In most cases, Paid-In Capital is initially small – the seed capital investment by a sole proprietor or a few founders for the start of the business. Any future infusions of equity – whether by private transactions or even initial public offerings subsequently add to the Paid-In Capital.

The more dynamic component of Equity is Retained Earnings, which represent the growth (or erosion) of equity throughout the life of the company. For each balance sheet period, the net income of the company from the Income Statement is taken and added to the previous period’s Retained Earnings. For example, if your Company had $200,000 of Retained Earnings and generated $35,000 of Net Income for the year, your Retained Earnings for that period’s Balance Sheet would be $235,000. Note that Retained Earnings can decrease (or even become negative) if the firm generates substantive losses (expressed as negative net income on the Income Statement).

In the next post, we will address the specific categories of Assets. We will examine various Asset types in more detail, as well as summarizing several key accounting ratios that can be used to examine the health of a firm. Thereafter, we will do the same with Liabilities.

You may wish to review other posts in this series, including:

Corporate Finance and the Entrepreneur

Leaping the GAAP

The Entrepreneur and the Income Statement

My EBITDA is Bigger Than Yours.

Income Statement Hide and Seek

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About the Author

I have spent the last 15 years advising entrepreneurs on starting and growing their businesses, as well as assisting in financing those growth efforts. I have also been an entrepreneur on several occasions myself. By writing this blog, I hope to provide actionable advice on how to achieve your goals and become more successful.
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