A balance sheet or statement of financial position is a summary of a company’s assets, liabilities and shareholder equity at a specific time – a handy snapshot of financial health. It is one of the three major financial statements used by owners, managers, investors and accountants (the other two being the income statement and cash flow statement). Balance sheets will often be composed as of the end of the financial year, semi-annually or quarterly and allow you to see exactly what a company owns as well as what it owes to other parties as of the date indicated in the heading. The balance sheet is therefore a very important measure as to a company’s creditworthiness!
So how is a balance sheet structured? Well, the main categories of assets are usually listed first, and typically in order of liquidity (the ease at which those assets would be able to be sold), which means that cash along with other current assets are listed first followed by fixed assets like property, plant and equipment with the most illiquid assets like intangible assets and everything else listed last. Generally there is more certainty as to the value of liquid assets than illiquid assets and it can very hard to value things like intangibles, which is why investors often look at the net tangible assets of a company when considering its value. Assets are then followed by the liabilities, which are a company’s legally binding debts or obligations. Examples of liabilities include: accounts payable, debt, minority interest and negative goodwill. The difference between assets and liabilities is the shareholder equity or net worth of the firm. Therefore, rearranging gives the balance sheet equation that a company’s total assets (everything it owns) equals total liabilities (everything it owes) plus total shareholder equity (shareholder capital + retained earnings – treasury shares). Looking at the equation in this way shows how assets were financed: either by borrowing money (which becomes an IOU, a liability) or by using the owners’ funds (usually written as shareholders’ equity).
Total Assets = Total Liabilities + Total Shareholder’s Equity
Why is a balance sheet called a balance sheet? It’s quite simple, really: everything on it must always balance out! On a balance sheet, the sum of a company’s assets must always equal its liabilities + shareholder equity. However, there’s an even easier way to understand it. Total assets (meaning everything on the balance sheet) are always equal to the claims on those assets – the people who own them.
Total Assets = Total Claims On Those Assets
Think about it: what are liabilities but the claims of other people or organisations, for example banks, stockists, and personal creditors, on your assets? Similarly, shareholder equity simply denotes the part of the company that shareholders own, and would claim if the company were to suddenly cease function.
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