Balance Sheet Basics

 

The Balance Sheet is a condensed statement that shows the financial position of an entity on a specified date, usually the last day of an accounting period. This is a follow up to the post on Financial Statements.

Among other items of information, a balance sheet states

• What Assets the entity owns,
• How it paid for them,
• What it owes (its Liabilities), and
• What is the amount left after satisfying the liabilities (its Equity)

Balance sheet data is based on what is known as the Accounting Equation: Assets = Liabilities + Owners’ Equity.

Think of a Balance Sheet in terms related to everyday life. Home ownership, when you have a mortgage, is represented as a Balance sheet. Your home ownership basically has the three components of Asset, Liability and Equity. The Asset is the value of the house. This is determined by an appraisal. An appraisal takes into account recent sales of homes in the area and compensates for differences like the number of bath or bedrooms, the size of the lot, etc.

The Liability is the mortgage. This is how much you owe against the house. The Equity is the difference between the value of the Asset and the amount of the Liability. If your home is worth $200,000 and you have a remaining mortgage balance of $150,000, then you have $50,000 in Equity. We sometimes call this homeowner’s equity.

If your mortgage balance is more than the value of the home, then you are considered “upside down” or “under water”. The same principle applies to a business: if the value of its Liabilities is more than the value of the Assets then the enterprise is insolvent and probably headed for bankruptcy.

A Balance Sheet is organized under subheadings such as current assets, fixed assets, current liabilities, Long-term Liabilities, and Equity With income statement and cash flow statement, it comprises the financial statements; a set of documents indispensable in running a business.