FINANCIAL STATEMENT LITERACY (2 of 4) What is a Balance Sheet?

The balance sheet is the first of three major financial reports included in a company’s financial statements.?A balance sheet lists the assets (things the company owns that have value), liabilities (things the company owes), and equity (the value of the company).

If you’re a non-accountant your eyes have either glassed over, or you are considering moving on to read something less technical.?But hang in there!?Believe me, you’ve got this and don’t even know it.?You already understand what assets and liabilities are, and what equity represents.

For example, think of a home worth $200,000 and a mortgage for $150,000.

Caught you!?What did you just do??If I’m right, you just subtracted the mortgage from the home value.?Am I correct??Without any prompting, you were calculating “equity”, the difference between assets (home) and liabilities (mortgage).?But why?

Even if you’re a non-accountant you just created a balance sheet in your head and used that balance sheet the same way your banker does.?You naturally “sold” the home, paid the mortgage, and calculated how much you would “take home” (equity or net worth).?But you also did something else, that I didn’t tell you to do.?You instinctively recognized that a balance sheet represents values “at a moment in time”, a photograph, if you will.?In other words, without a complete definition of what a balance sheet is, you understand that the calculation you performed would yield a different answer if you calculated it next month or next year, because the value of the home and the mortgage would be different.

Do you still think you can’t understand what a balance sheet is, what information it conveys, and why it’s important in telling a part of the story about a company??Give yourself a pat on the back for getting this far in the article and not giving up just because I threw out some accounting terms.

My example was a very simple one but understanding the concept of a balance sheet is the important part.?Understanding that “assets minus liabilities equals equity” will allow you to not only “read” your company balance sheet, but even the most complex Fortune 500 company balance sheet.?Every balance sheet includes a line for “total assets”, “total liabilities”, and total equity”.?So even though there may be a billion line items that make up total assets and liabilities on a publicly traded company’s balance sheet, you can still calculate how much the company is worth.?Really cool, right??You’re so smart!

You can stop reading here if you like.?You’ve already proven to yourself you know what a balance sheet is.?Or you can continue reading and take your understanding to the next level.

If you’re still reading, you need to contact ARI right now!?You are the perfect client for ARI because you demand more from your Trusted Advisor.?You want knowledge.?You want information, but you want to understand it.?ARI is a completely cloud-based firm that works with start-up and troubled small companies. We love small businesses and helping them grow.?We believe that an educated client is a more successful client.?We use technology to automate and simplify the running of your company, so we can spend more time discussing with our clients how to run their companies better.

Okay, so that’s the end of our blatantly obvious commercial “plug”.?On to more information you can use, even if you’re not an ARI client.

Your company balance sheet is more complicated than one asset and one liability.?Let’s look at what an asset and liability are.

An asset is either “cash”, something that will be converted to cash in one year, or something “cash” was spent on and will benefit the company for more than one year.

Whew!?Techno-speak.?Did I lose you??You wanted extra credit, you had to know I was going to push you into unfamiliar territory.

The assets on your balance sheet are listed in the order of the amount of time it takes to convert them into cash.?Depending on your company, the first asset on your balance sheet is either petty cash or your company checking account.?Why does petty cash appear before your checking account??Because if you open your petty cash box, what’s inside??Cash, actual dollar bills, and although your checking account balance “represents” cash, you still must write a check to access the actual cash (it takes more time than petty cash to convert to cash).

What other assets appear on your balance sheet??Next might be accounts receivable.?Literally, a piece of paper that has value, and hopefully will be paid by your customer and converted into cash within 30 days.?Next, maybe employee loans, that over the next few weeks or months will be converted (through payroll deductions) into cash.

Assets that will be converted into cash within the next year are subdivided into a category called current assets (they’re still assets).?Assets that will convert to cash in a period longer than a year are called long-term assets

Examples of long-term assets are loans to stakeholders or others, fixed assets (vehicles, equipment, buildings, improvements, and land), and then finally, intangible assets (goodwill, client lists, and noncompete agreements).?These items represent “cash” spent on something that has value to the company over a period lasting longer than a year.

Fortunately, liabilities on your balance sheet follow the same rules as assets. They appear in the order in the amount of time it takes to convert them into cash.?Depending on your company, your first liability could be “checking overdraft” or your accounts payable (amounts you owe your vendors).?Why would “cash overdraft” appear before accounts payable??Because you’ll have to put more money in your checking account (to cure the overdraft) before your bank will honor anymore checks.

What other liabilities appear on your balance sheet? Next might be accounts payable.?An amount you are obligated to pay within 30 days.?Or taxes payable and paycheck withholdings, both payable within one year.

Liabilities that will be converted into cash within the next year are subdivided into a category called current liabilities (they’re still liabilities).?Liabilities that will convert to cash in a period longer than a year are called long-term liabilities.

Examples of long-term liabilities are loans from stakeholders or others like bank loans and mortgages.?These items represent “cash” received for something that have value to the company over a period lasting longer than a year.

Finally, the final section of the balance sheet is the equity section.?This section records the stakeholders’ original investment in the company (the purchase of stock), the cumulative additional investment in the company (the amount “given” to the company after the formation), the cumulative distributions to stakeholders (amounts taken out of the company), and the cumulative annual net income of the company since its formation.

The next article in this series will discuss the relationship of the income statement to the balance sheet (how the annual net income affects the balance sheet equity section) and what are income and expenses.

If you can’t wait until next month’s article and need help today, contact ARI. ?We’re all about providing you with more information to achieve your goals!

Other articles in this series: