One of the main financial statements used by decision makers in an organization is the balance sheet. The balance sheet shows the financial status of an organization at a specific point in time. It's a “snapshot” of how the firm is doing. It also referred to as the statement of financial position or the statement of financial condition. This differs from the income statement, which shows the performance of an organization over a period of time.
The balance sheet is broken up into three main areas. Assets, liabilities and owner's equity. A description of each category follows.
Companies have things of value such as cash, inventory, buildings and so on. These are called assets because they are expected to be used to generate cash inflows in the future.
Companies also have obligations such as supplier bills and bank loans that will result in future cash outflows. These are called liabilities.
Let's say you own a company. What this company is worth to you, the owner, is called owner equity (or Stockholders' Equity for corporations). Owner equity the difference between its assets and its liabilities. In other words, the company is worth what it has of “value” minus what it owes. We can write this “rule” out as an equation:
Owner Equity (Value of company) = Assets (What the company has of value) – Liabilities (What it owes)
The above "balance sheet equation" must always hold true or “balance”. A balance sheet lists items in each of these three categories (assets, liabilities and owner equity). Accountants prepare balance sheets with assets on the left side of the equation, and equity on the right side. We can rearranging the above equation to show that:
Assets = Liabilities + Owner Equity
Balance Sheet Essentials
- Assets: Resources that are expected to result in future cash inflow or a decrease in future cash outflow. Examples include, cash, inventory and equipment.
- Liabilities: Economic obligations of the organization to outsiders that are expected to cause a cash outflow or decrease in cash inflow. Examples include payables to suppliers and bank loans.
- Owner Equity: The remaining claims against the company's assets after deducting liabilities. It's essentially the amount left over after subtracting liabilities from assets. It includes the owner's investment and retained earnings. Retained earnings are the portion of profits reinvested in the business).
Short and Long Term Assets and Liabilities
On a balance sheet, assets are usually broken down into short-term (current) assets and long-term (Fixed) assets.
- Short-term assets are assets that are expected to be “used up” within the next year or so. Examples include cash and inventory.
- Long-term assets refer to assets that are held over a longer period of time. Examples include long-term investments, cost of property and equipment (e.g. land, buildings, equipment, tools, furniture, vehicles, etc.)
Similarly, liabilities are separated into current (short-term) and long-term liabilities.
- Current liabilities include the obligations to be paid within one year. Examples including accounts payable, short-term loans, income taxes payable, wages, and portions of long-term debt payable within the year.
- Long-term liabilities include long-term debt (e.g. mortgages), leases structured as loans.
Below is an example of a balance sheet for a fictitious enterprise called ABC Company Inc. You'll notice that the total assets equals total liabilities plus owner equity.
In this example, owner's equity includes the owner's initial investment and retained earnings. As mentioned, retained earnings result from company profits that are re-invested by the owners into the firm.
Accounting Software to the Rescue
Pretty much any modern accounting system software package will allow you to generate financial statements like the balance sheet based on the transactions that were entered. This is a big time saver because it makes producing financial statements by hand unnecessary. While it has become easy to create financial statements using software, it's still important to be able to read and interpret the statement.
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