Balance sheet is one of the most important terms in accounting. If you ever want to have your own company, you should learn about it. If you ever want to evaluate a company, you need to know how to read it. In any case this knowledge is important to anybody who wants to be an entrepreneur.
In this post I am going to describe what is a balance sheet and I will give an example that explains how and when you make changes of the balance sheet. This post is for you if you are interested in general knowledge in accounting. If you are already familiar with even basic accounting, you would not learn anything new here.
Time to read
Time to read: 6 minutes (based on 150 wpm)
What is a balance sheet
The balance sheet is a statement that summarizes what does a company own and what does it owe. The explanation cannot go any easier than that. Basically if you look at a balance sheet, you could see how well the company is doing. Based on the various parts of the balance sheet, you can calculate ratios, which are indicators of the health of the company. But about those ratios in other topics.
The golden rule of Accounting is that the two sides of the balance sheet should always be equal. Hence the term “balance”.
If we want to express that mathematically:
Assets = Liabilities + Equity
Assets comprise the left side of the balance sheet and the liabilities + stock options issues represent the right side of the balance.
The parts of the balance sheet
As you can see there are three important terms that have to be defined.
An asset is everything that the company owns. The assets could be further divided into current (those that can be converted to cash within 1 year) and long-term (those that cannot be converted to cash so fast) assets.
Examples of current assets:
- Cash (the money in a corporate account)
- Accounts receivable (the money that customers owe the company, e.g. for goods that are sold to the customer but the cash is not yet received)
- Inventory (the goods ready for sale, the goods that will be used in producing other goods)
- Prepaid expenses (the expenses that have already been paid for, such as insurance, prepaid tax)
Examples of long-term assets:
- Investments (the company cannot convert them to cash within 1 year)
- Fixed assets (land, machinery, tools)
- Intangible assets (not physical but still valuable, like intellectual property)
Liabilities are money that a company owes to the outside world. They are also divided into current and long-term liabilities.
Examples of current liabilities:
- Account payable (the money that the company owes to suppliers, for goods that are already part of the inventory)
- Financial liabilities (wages, interest, rent, utilities)
- Current portion of long-term debt (what the company owes within 1 year on its debt)
- Customer prepayments (the money from customers who have paid, but have not received the goods)
Examples of long-term liabilities:
- Long-term debt
- Deferred tax (taxes not yet paid)
Equity is what a company owes to its shareholders.
Examples of equity:
- Issued capital (or stock)
- Retained earnings (earnings received)
Example of balance sheet
It is easier to explain the balance sheet with an example.
Step 1: You found a company
The first step is really easy. Let’s say that you own a company and you have invested $10,000 in the company. Your balance sheet looks like this:
In brackets you can see the change in the different accounts on the current step.
First we enter the $10,000 cash that the company receives from you as an investment. Since the two parts of the balance sheet should balance, you also need to enter something on the right side. And this is exactly the “issued capital” or stock.
Step 2: The company buys a shop
This is an oversimplified example, but let’s say that your first move is to buy a shop. You pay $5,000 in cash and you loan another $15,000. The loan is interest-free for the first 2 years.
On the left side of the sheet you enter your new shop under long-term assets and you subtract $5,000 from your cash reserves. In order to balance the sheet, you enter $15,000 on the right side under long-term liabilities.
Step 3: You buy inventory
Your next steps is to buy some inventory (e.g. apples) that you are going to convert to juice. You buy $2,000 worth of apples, you pay $1,000 in cash and you promise to pay the rest at the end of the month.
On the left side of the sheet you now have $2,000 apples as inventory. You subtract $1,000 from your cash. And last but not least, you add $1,000 on the right side as account payable. Wonderful! Your balance sheet is “balanced”!
Step 4: You turn the apples into juice and sell some of it
Your business is doing great and you managed to sell $1,000 worth of juice by using $500 worth of apples.
You add $1,000 to your cash reserves. You subtract $500 from apples. In order to balance the sheet, you also need to enter your earnings and you do that as “retained earnings”.
The balance sheet is an easy to understand, but very difficult to complete and maintain. As an entrepreneur you would only have to deal with that concept as soon as your company is big enough to require advanced (or complex) accounting. In most countries you only have to keep basic accounting as long as you are a self-proprietorship company and you are under a predefined threshold of income.
Once your company is big enough, I recommend you to hire an accountant and let him or her do that stuff for you. But in any case, you need the knowledge of how to read a balance sheet if you want to progress.