Reading a balance sheet is instrumental in understanding the business’s financial position. This particular financial report is a snapshot of a moment in time. It can change dramatically in a minute so understanding the perspective of the report and its respective sections will help you to be better informed.
What is a balance sheet? It is considered one of the five basic financial reports of any company. In reality, most folks can only interpret the two most fundamental reports, the Profit and Loss and the Balance Sheet. The other three reports require a lot of background information to read and interpret the information correctly. Of course this didn’t answer your question as to what is a balance sheet.
This report basically identifies where the money came from, and where is it located. Huh? The best way to explain is to illustrate a basic transaction. Let’s start out with the first day of business. On the first day, you as the owner purchased the stock and/or made a capital contribution, normally in cash and so the balance sheet will display the following:
. Balance Sheet
Cash in a bank account $ZZ,ZZZ
Total Assets $ZZ,ZZZ
Capital Contributed from Somebody (You) $ZZ,ZZZ
Total Liabilities and Capital $ZZ,ZZZ
Now note that the balance sheet is like a scale, on one side sits assets of some sort (where the money is located) whether physical in nature or intangible like buying a patent or a copyright. All of this combined is referred to as Total Assets. On the other side sits two major groupings of where the money was sourced. You could borrow the money which is referred to as a liability or you could have contributed the money which is referred to as Capital. Both liabilities and capital are added together to create Total Liabilities and Capital.
TOTAL ASSETS SHOULD ALWAYS EQUAL TOTAL LIABILITIES AND CAPITAL.
Thus the balance sheet in simple format, but business isn’t that simple. Let’s complicate this a bit. The very next day, you decide to buy a truck to use in the business operation. What happens now?
Let’s assume that you contributed $10,000 to the company on day 1, and on day 2, you buy a truck for $3,000. However, you didn’t want to give up all that cash for a truck, so you decided to borrow $2,000 of the dollars. Let’s walk through the result on the Balance Sheet. For assets, you now have $9,000 in cash (the original $10,000 less the $1,000 put towards the purchase of the truck) and a truck for $3,000. You have total assets of $12,000. Ok, now what does the other side of the balance sheet look? Well, there we have a liability of $2,000 (the amount we borrowed to buy the truck) and the $10,000 we original invested into the company or the capital. So now the balance sheet looks like this:
. Balance Sheet
Cash in the bank $9,000
Fixed asset of a truck 3,000
Total Assets $12,000
Loan from some institution for a truck $2,000
Capital Invested 10,000
Total liabilities and Capital $12,000
Note that they equal each other. Now why didn’t we just expense out the truck? Well for one thing it’s a fixed asset and we should depreciate this over time or as we use the truck in the day-to-day operations. But let’s say that we did expense out the truck, because it’s a piece of junk and we know it’s only good for one haul of materials and then we have to ditch the truck. What happens here? Well, when a company makes a profit or loses money, that bottom line from the Profit and Loss statement ends up in the capital area of the Balance Sheet. The reason is that this benefit or loss (responsibility) belongs to the investor (you). This is recorded in the capital section of the balance sheet and is referred to as earnings. The word we use as accountants is Retained Earnings. Anyway, we know that we used the truck up in one day. We didn’t earn any money, the only cost was the truck so the Profit and Loss says we lost $3,000. Now how does the balance sheet look? Let’s see:
Day 2 of Operations, Lost a Truck
Cash in a bank $9,000 Remember, only $1,000 in cash for the truck was put up.
Total Assets (Truck is gone) $9,000
Loan from some institution for a truck 2,000
Capital Invested 10,000
Loss from Profit & Loss (3,000) Simply stated, the value of the truck
Total Liabilities and Capital $9,000
The balance sheet is divided into three major sections for Assets and two major sections for Liabilities and Capital. Below is a description of each of the major areas and in the next article on this subject, I get into some details about reading and understanding these sections.
Current Assets – this is generally cash and what we refer to as cash equivalents which include receivables from customers, inventory you purchase to resell, or raw materials you buy to turn into products. This section also includes short-term loans you make to others including employees, and prepaid items for future services or materials.
Fixed Assets – this is generally large ticket items such as heavy equipment, transportation vehicles, office equipment, storage units or items you buy that will be around for a long time and that you’ll use on a daily basis.
Non-Current Assets – these become more common as the company grows and prospers. They include deposits made or held for long-term contracts (like the utility deposit or rent deposit); goodwill, or the start-up costs you incurred to get this business going.
Liabilities and Capital
Liabilities- these are debts to various parties. They include suppliers and other vendors and they are referred to as Accounts Payable. We also include credit card debt (the company’s credit card(s)) and short-term liabilities such as temporary notes, taxes owed, or payroll items. Other types of liabilities include long-term. This includes notes we use to purchase long-term assets such as fixed assets. Both of these combined make up Liabilities which is one major section of one side of the balance sheet.
Capital – this comprises the invested amounts plus any earnings or losses incurred to date.
Learning to read and understand a balance sheet is instrumental in evaluating a business operation. By understanding the simple format as explained above, you are on your way to learning more complex aspects of reading and understanding the balance sheet. Future articles will get involved in each of the respective areas and how to grasp what they really mean. Act on Knowledge.