The balance sheet reflects the assets, liabilities, and owners’ equity at a point in time. In other words, it shows, on a specific day, what the company owns (assets), what it owes (liabilities), and how much its worth (equity) is. The balance sheet is called such because it balances, assets must always equal liabilities plus owners’ equity. A financially savvy manager knows that all the financial statements ultimately flow to the balance sheet.
Assets = Liabilities + Owners’ Equity
One goal of a company is to increase profitability, another is to increase equity. As it happens, the two are intimately related. Consider this analogy. Profitability is sort of like the grade you receive for a course in college. You spend a semester writing papers and taking exams. At the end of the semester, the instructor tallies your performance and gives you an A- or C+ or whatever. Equity is like your overall grade point average (GPA). Your GPA always reflects your cumulative performance, but at only one point in time. Any one grade affects it, but doesn’t determine it.
The income statement affects the balance sheet much the way an individual grade affects your GPA. Make a profit in any given period, and the equity on your balance sheet will show an increase. Lose money, and it will show a decrease.
Shown below is a sample balance sheet, amounts shown in thousands (000’s).
(Excerpts from Financial Intelligence, Chapter 10 – Understanding Balance Sheet Basics)
Since the balance sheet is so important, we want to begin with some simple lessons.
Start by considering an individual’s financial situation, or financial worth, again at a given point in time. You add up what the person owns, subtract what she owes, and come up with her net worth:
Owns – owes = net worth
Another way to state the same thing is this:
Owns = owes + net worth
For an individual, the ownership category might include cash in the bank, big-ticket items like a house and a car, and all the other property the person can lay claim to. It also would include financial assets such as stocks and bonds or a retirement account. The “owing” category includes mortgage, car loan, credit card balances, and any other debt.
Now move from an individual to a business. Same concepts, different language:
- What the company owns is called its assets
- What it owes is called its liabilities
- What it’s worth is called owners’ equity or shareholders’ equity
And the basic equation now looks like this:
Assets – liabilities = owners’ equity
Assets = liabilities + owners’ equity