What exactly Balance Sheet is?
Every textbook definition will be half-page long and difficult to understand. But in simple words, we can say that it is one of the key financial statements and that it shows clearly what a particular company owns and where the money to finance those things comes from. Usually, a balance sheet is created for the period of one year, however, it might be created more often.
How does a basic Balance Sheet look like?
Balance sheets consist mostly of three main items. These are: Assets, Liabilities, and Equity:
Assets are all the goods the company OWNS. They can be for example computers, cars, buildings, software, and so on.
Liabilities – simply represent what the company owes. For example, 10-year loan to finance a purchase of a new building would be a liability.
Equity – this represents the what the company owners invested into it. It can include share capital for example.
A simplified Balance sheet looks like this:
Very Important Rule!
There is one very important requirement every balance sheet needs to meet in order to be correct. This is called the Accounting Equation. It looks like this:
ASSETS = EQUITY + LIABILITIES
But why do we create equations like the one above? Try to come back to what the three figures in this equation represent. Assets tell us what the company has, and the sum equity + liabilities tells us, where did the money to gain those assets come from. This implies simply that assets MUST equal to equity and liabilities added together. If assets were higher than equity and liabilities, that would imply that company for example could engage in some illegal activities since it could be willing to hide some sources of funding.
In other words, the company cannot have more assets than the funding it obtained. And vice versa, equity and liabilities cannot be higher than assets as well.
For example:
On 1st March 2020, a company ‘British Weather’ has £10,000 cash, and a building worth £80,000. Share capital is £75,000, and the company has long-term loan of £15,000. On 15th March it bought a car worth £20,000 and the purchase was financed from the short-term loan. How will the balance sheet look like at 1st March 2020 and 31st March look like?
Balance sheet at the beginning of March 2020:
On the 1st March 2020, we put Building and Cash on the Assets Side, because they represent what the company has. Share Capital and long-term loan show where the company took the money from. Together, assets amount to £90,000, which is the same as equity + liabilities. Therefore, the balance sheet is correct – the equation agreed.
Now, let’s take a look what happens when the company buys the car. It pays £20,000 to buy this car. This money comes from a short-term loan. The car the company buys, will be its asset – the company will own the new car. The short-term loan which was made, is a source of funds to buy a new car (company borrows £20,000, and then it pays this money to get a car).
Thus, we have added a car on the left-hand side, and a short-term loan on the right hand side. The Total Assets figure is equal now to £110,000, which is the same as Total Equity and Liabilities figure. Thus, balance sheet is prepared appropriately.
What if we made a mistake?
For example, assume that we added a car to a company’s assets, but we did not add the short-term loan. What would happen? Let’s analyse it step by step. Our assets would be:
Assets = £80,000 (building) + £20,000 (car) + £10,000 (cash) = £110,000
However, our equity and liabilities would be like this:
E&L = £75,000 (share capital) + £15,000 (long-term loan) = £90,000
£110,000 ≠ £90,000 → Assets ≠ Equity + Liabilities
Assets now equal to £110,000 and Equity plus Liabilities now equal to £90,000 since we did not add the short-term loan, which the company used to finance its car. The different amounts for Total Assets and Total Equity and Liabilities indicate that the mistake has been made, and that the balance sheet is prepared incorrectly.
Why do we prepare the Balance Sheet?
There are multiple reasons for which companies prepare their balance sheets. Firstly, in many countries it is simply required by law to do so. Balance sheet can be used for taxation-purpose reporting, and the state’s authorities might use the company’s balance sheet to control whether it operates legally (i.e. that the company is not engaging in illegal activities).
Secondly, balance sheet combined with other key financial statements is often used to assess a particular company’s performance by investors. Investing decisions very often rely on company’s performance and its comparisons to other companies. Basing on the balance sheet, investors are better able to asses how risky an investment into a particular firm is, and whether that entity is likely to bring expected returns. There are some other reasons, for which companies prepare balance sheets, but the two mentioned above are the most important.
Summary:
Balance sheet is one of the key financial statements.
It consists of asset side and equity and liabilities side.
Every balance sheet must meet the asset-liability requirement, called also an Accounting Equation: ASSETS = EQUITY + LIABILITIES
If we increase anything on the asset-side, we must also increase the equity & liabilities side by the same amount – everything the company has must have the source of its financing
Balance Sheet is prepared mainly for external reporting purposes – it is required by law in many cases, and it is used by investors when making investing decisions.
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