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Understanding Financial Statements: Part 2 – Balance Sheets

5 mins read

This article explains what Balance Sheets are, as they are an important financial statement to be aware of.

Many of us don’t like to be surprised and want to have a well-balanced life, which is why in the accounting world balance sheets are used to make world go round! Balance sheets are important as they provide businesses with a snapshot of what is owned, owed, and the amount of equity invested (shareholders) as of a certain date. In short, balance sheets refer to a financial statement that reports on a business’s assets, liabilities, and equities which provide a basis for computing ROI (Return on Investment) and evaluating capital structure (i.e. used to evaluate a company’s overall operations and growth).

The fundamental purpose of a balance sheet is to calculate financial ratios, so internal and external stakeholders are informed of a company’s financial stability using ratios such as current ratio, debt-to-equity ratio and acid-test ratio to name a few. This statement follows the accounting equation:

This formula is intuitive, because it displays what a business must pay for everything it owns (assets) which is generally done by borrowing money (liabilities) or receiving financial support from investors (shareholder equity). The assets should always equal the liabilities and shareholder equity, meaning the balance sheet should always balance.

Similar to our personal lives, when there is an imbalance, there may be some underlying problems. Taking this into accounting, some problematic areas could be incorrect or misplaced data, inventory and/or exchange rate errors, or miscalculations. The main purpose of a balance sheet is to reflect every transaction that a business has since its conception, which reveals its overall financial health. At a high-level view, you will know exactly how much money you have invested or how much debt was accumulated.

What is Included on a Balance Sheet?

Much like an income statement, all data found are details for a specific time-period. However, a balance sheet generally includes assets, liabilities, and equity which are used alongside the 2 other types of finance statements (income statement and cash flow statement).

Example of a Balance Statement

In the example, we see the details from Company XYA from September 30, 2021.

You can see there are 3 sections on the sheet: Assets ($191,500) = Liabilities ($10,200) + Equity ($181,300); which gets final total of $191,500 – the same as the total assets.

Assets

Assets are quantifiable things your business owns with a dollar value (liquidity) or can be turned into cash, sold, or consumed.

      1. Current Assets: anything you can convert into cash easily within a 12-month period such as money in a bank account, money in transit, accounts receivable, short-term investments, inventory, prepaid expenses, and cash equivalents (currency, stocks, bonds, etc.).
      2. Non-Current (Long-Term) Assets: anything you cannot convert easily or don’t plan to convert into cash within a 12-month period such as fixed assets (property, land, machinery, and equipment) and intangible assets (patents, trademarks, goodwill, etc.), or long-term investments.

Liabilities

Liabilities are things your business owes to others. Just like assets, you will want to classify these as ‘current’ and ‘non-current.’

      1. Current Liabilities: accounts payable, wages payable, loan payments, interest payable, taxes, etc. expected to be paid within a 12-month period.
      2. Non-Current (Long-Term) Liabilities: loans you don’t have to pay back within a 12-month period or bonds that your company has issued.

Equity

Equity is money currently held by your company and shows what belongs to the business owners. This is commonly called “owner’s equity” or “shareholder equity” which includes capital (money invested into the business by owners), preferred or common stocks, private or public stocks, retaining earnings. Equity can also drop when an owner draws money out of the company to pay themselves, or when a corporation issues dividends to shareholders.

Now that you have been introduced to Balance Sheets, please stay tuned for part 3 of this series when we discuss Cash Flow Statements.

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