Balance Sheet

This statement measures the position of a firm. It indicates the overall short-term and long-term stability of a business. 

A Balance Sheet displays what a business OWNS (assets) and what a business OWES (liabilities and Owner’s Equity) at a single point in time.

The Balance Sheet balances. 

The Accounting Equation is:

Assets = Liabilities + Owner’s Equity

The balance sheet balances because everything that a business owns (its assets), had to have been financed with money from somewhere (liabilities—other people’s money and owner’s equity—owner’s money).

Key Terms:

Asset:  items of value that a business owns. These could include a factory, stock, cash, Accounts Receivable, cars, and goodwill (intangible value of business reputation / brand).

Liability: money owed to other businesses and financial institutions (external source of finance). These could include credit card debt, business loans, mortgage, bonds, Accounts Payable (trade credit owed to suppliers for inputs). Typically, these items must be repaid and accrue interest (cost). Debt is useful and good.. It can expand business production and boost profitability. But not too much!

Owner’s Equity: the funds that owners and shareholders have contributed to finance the firm’s operations. These include initial investments, additional equity injections, and retained profits. This is an internal source of finance. This is the money that the business owes to the owners. Owners can ‘draw’ out funds from the business; this is when an owner removes some free cash, lowering the level of Owner’s Equity.

Liquidity: the ability for a firm to pay obligations as they fall due (related to cash flow management and projections)

Solvency: the overall, long-term financial stability of the firm (debt / equity vs revenues levels derived from business activity). Insolvency can result from over-extension of finance.

Note:

• Current assets are expected to be turned into cash within 12 months.

• Current liabilities are expected to be paid within 12 months.

• Cash is the most liquid asset.

• A profitable firm that retains those profits for growth continually builds the owner’s equity in the firm (what the business owes the owner).

• An unprofitable firm will continually eat into the owner’s equity of the firm and deplete cash levels.