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What is a balance sheet

A balance sheet is a financial report/statement that shows what the business owns and what it owes. In other wards, the balance sheet shows you the monetary value of your business or how much your business is worth. You always hear people announcing how much different companies are valued at/net worth on the stock exchange, on the news, on the internet, and in your neighborhood. The professionals actually base it on the balance sheet to determine this, and in this short article you will know how they do it.

Components of a balance sheet

The balance sheet is comprised of three major components, namely:

1)     Assets

These are tangible and non-tangible things owned by the company/business that generate income, preserve income, or multiply income.

These include:

1. Non-current assets, or fixed assets, that a business owns for a long time (more than 12 months), like land and buildings, furniture and fittings, and machinery and equipment.
2. Current assets are owned by the business for shorter periods of time, and they can easily be converted to cash, like inventory or stock, debtors/receivables, cash, and cash equivalents.

2)     Liabilities

This is simply that the company owes other people, companies, entities, banks, etc.

Liabilities are also divided into two:

1. Non-current liabilities, which the business owes/pays back in a long time (normally more than 12 months)like long-term loans etc.
2. Current liabilities, which the business owes/pays back in a shorter period of time, like short-term loans.

3)     Equity

Owners’ equity includes the other sources of funds for the business and how they are dispatched and also withdrawn from the business.

Owners’ equity is divided into four major parts:

1. Capital/share capital, which is money the owner or shareholders/investors have invested in the business.
2. Net profit/loss, which is the current profit or loss the business is making or incurring, respectively.
3. Retained earnings/losses, which is profit retained from previous periods or losses brought forward from previous periods.
4. Dividends/drawings, which is money paid out to shareholders or investors from the profits in a company or money the owner withdraws from a sole proprietorship for personal use, respectively. Dividends/drawings are also called contra-capital accounts because they reduce the capital in the business.

Why the balance sheet must (not should) always balance

Ok, let me simplify why, like I am explaining it to a 5-year-old.

A business/company generates money/income in three major ways:

1. Capital/share-capital from owner or owners/investors
2. Profits from sales/operations
3. Loans from financial institutions or investors

The first two are under owners’ equity, and the last one is under liabilities on every company’s balance sheet.

The company then uses this generated money/income to purchase or create assets. Not so?

The balance sheet equation is EQUITY + LIABILITIES = TOTAL ASSETS

This is why the balance sheet must always balance because the SAME money/income flows from the equity and liabilities to the assets.

This is how double-entry accounting keeps itself in check for accuracy.

How to determine the value/net worth of the company using the balance sheet

To determine the value/net worth of a company using the balance sheet, we subtract the liabilities from equity to get the total net worth of the business and its assets.

Therefore the value/net-worth of a business = OWNERS’ EQUITY – LIABILITIES

So the next time you hear that your favorite sports team or clothing brand is worth $5 billion or $10 billion, don’t wonder how they came up with that big figure because now you know how their accounts do it using the balance sheet.

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