Beginners guide to balance sheet

Balance sheet is prepared by accountants to present the balances of company’s asset, liabilities and equity on the last day of the profit period. Balance Sheet can be defined as a snapshot statement that shows what a company’s assets are, what its liabilities are, and what its equity is at a specific point in time. Balance sheet is also known as statement of financial position.

Balance sheet can also be defined as a statement prepared to show company’s assets, liabilities and owner’s equity as on a particular date .

It shows the fundamental soundness of a company by reflecting its financial position at a report date. In a traditional balance sheet, assets are shown on the right side and liabilities on the left side. As the left and right sides balance each other, its known as balance sheet.

In simpler terms, balance sheet is a statement which shows the things that an organisation owns (the assets) as well as the sources of finance used to buy them (the liabilities and capital).

Assets are company’s valuable resources owned or controlled to make money. Liabilities are the obligations of the company to convey something of value in the future. Owner’s equity refers to the shareholders interest in the business.

Specific point in time can be the end of the year or quarter or month. If you are preparing financial statements for a month then specific point in time for a balance sheet in this case will be the end of the month. Specific point in time is also known as report date. However, your accountant can prepare balance sheet at any time that you want to know how things stand financially.

As stated at the beginning, balance sheet has three principal component. Components of balance sheet can be shown by following equation, its known as “basic accounting equation”;

Assets = liabilities + owner’s equity

By definition, the above equation must always be in balance with assets equalling the sum of liabilities and equity. We can say, assets of the company are financed by liabilities and equity. This means assets can only be bought with funds provided by the owners or borrowed from someone else, for example, bankers or creditors

From this accounting equation, you can find owner’s equity or company’s net worth by subtracting liabilities from assets.

Assets – liabilities = owner’s equity

This means what the company has today (assets) minus how much the company owes today (liability) is equal to what the company worth today.

Owners equity contains the retained earnings balance that accumulates every year by adding net income to it t the end of the year.

However, this simple equation will not give complete answer to company’s financial position. To know the type and amount of asset, liability and capital account at the end of the period, company prepare balance sheet with classifications of these major items.

Each part of this accounting equation are discussed below.

Assets – In balance sheet it shows what you own

Assets are anything of value that a company owns to produce goods for sale in the future such as plant and machinery,inventory and building. Assets are of two main types and are classified under the headings of either  fixed assets or current assets.

Fixed assets are the hardware or physical things owned and used by the company and are not sold to customers. Examples of fixed assets include buildings, plant, machinery,  vehicles, computers, furniture and fittings.

Current assets are cash, things that will be converted into cash within a year from the date they are listed on the balance sheet. Example of current assets include stocks, work-in-progress, marketable securities, trade accounts receivable, bank balance, cash, prepaid expenses and assets.

Therefore we can say:

Total assets = Fixed assets + Current assets.

Fixed asset and current assets are further broken down into short-term and long-term assets.

Current assets

Current assets are things that the company owns which can be converted or sold to generate cash within a year or operating cycle.

Here are main components of current assets:

These are also known as short term assets as it can easily get converted to cash to meet business obligations.

Long-term assets

  • Plant and machinery
  • Goodwill
  • Intangible assets
  • Capital work in progress
  • Land

Liabilities – What the company owes to outsiders

During the normal course of business, company will have vendors, suppliers, bankers, financial institutions and other parties from whom it would have received raw material, services or finance on credit.

Liabilities are what the company owes to outside parties or are obligations of the business. A company might owe money to employees, vendors, banks and government agencies. Liability on the balance sheet shows how much cash will be needed to settle these debts.

If liabilities are not settled during the accounting period, demand from these parties to be paid by the company is shown in the liabilities section of a balance sheet by breaking it down to following main parts:

A liability will be classified under the head current liabilities if bills are due within a year time or within the operating cycle of the company. Long-term liability needn’t be paid for at least a year.

Liabilities and owner’s equity represent claims against a company’s assets. That’s why the balance sheet balances.

Owner’s equity – Net Worth of the company

Owner’s equity is the stake that shareholders have in the company, which is also known as shareholders equity. It reflects ownership.

In case of partnership firm and proprietorship business, it’s called partner’s equity or capital and owner’s equity respectively. It shows what the company is worth to its owner.

Shareholders equity is simply the difference between company’s assets and liabilities. This means, if the company sell all of it’s asset at book value and uses the proceeding to pay liabilities, then whatever left out with the company will be given to owners. Owner’s capital is also known as net worth of the company.

Retained earning is last year’s retained earning plus this year’s profit carried forward to balance sheet. It’s part of company’s net worth.