To understand the financial position of a business at a specific point of time, look at the balance sheet. The balance sheet may also be called the statement of financial position. Together with the Profit and Loss Statement (or Income Statement), and possibly other reports such as the Statement of Cashflow, these reports provide a complete understanding of the financial position and business performance.
So what’s involved? – The balance sheet has three sections: assets, liabilities and equity.
What you own (assets)
– What you owe (liabilities)
= What your business is worth (equity)
What are Assets?
Assets are things and resources that a company owns. They have current and/or future value and can be measured in currency.
Assets may be subdivided on the balance sheet into bank accounts, current assets, fixed assets, inventory, non-current (or long term) assets, intangible assets and prepayments.
These include bank accounts, accounts receivable, property, equipment, vehicles, investments, and intellectual property. All of these can be translated into monetary value.
What are Liabilities?
Liabilities are amounts owed to suppliers and other creditors for goods or services already received. Liabilities may also include amounts received from customers in advance for future services yet to be provided by the business.
Liabilities are generally subdivided into current and non-current liabilities.
These include accounts payable, payroll obligations, customer deposits received, and loans.
What is Equity?
Equity includes owner contributions, owner draws, current year earnings, cumulative prior year earnings (retained earnings), and stocks. The value of the equity equals assets minus liabilities.
Transactions that affect profit and loss accounts also affect balance sheet accounts. The profit and loss shows the net gain or loss in a given period, which is reflected in the current year earnings on the balance sheet.
The Balance Sheet Equation
The balance sheet must always balance! Assets = liabilities + equity.
For example, you buy a new vehicle for the business for $50,000, having paid a $10,000 deposit and taken out a $40,000 loan. The value of fixed assets (vehicle) is $50,000, but the bank value decreases by the $10,000 deposit paid leaving a net gain of $40,000. And the value of liabilities increases by $40,000 for the loan. The $40,000 increase in assets equals the $40,000 increase in liabilities, leaving the balance sheet balanced on both sides of the equation.
The balance sheet equation shows you how much money you would have left over if you paid all your bills and debts and sold all your assets at a given date. This amount is the Equity.
Note that the balance sheet equity total is not necessarily how much the business is worth at market value. Assets are listed on the balance sheet at their transaction value (what they cost at the time of purchase), which may be very different from the market value. Some assets may be worth more, and others may depreciate in value. Business value is calculated not just on the balance sheet figures but many other factors.
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