What Is A Balance Sheet?
The Balance Sheet presents the financial position of a company at a given point in time. It is comprised of three parts: Assets, Liabilities, and Shareholder’s Equity.
Assets are the economic resources of a company. They are the resources that the company uses to operate its business and include Cash, Inventory, and Equipment. (Both financial statements and accounts in financial statements are capitalized.)
A company normally obtains the resources it uses to operate its business by incurring debt, obtaining new investors, or through operating earnings. The Liabilities section of the Balance Sheet presents the debts of the company.
Liabilities are the claims that creditors have on the company’s resources. The Equity section of the Balance Sheet presents the net worth of a company, which equals the assets that the company owns less the debts it owes to creditors.
In other words, equity is comprised of the claims that investors have on the company’s resources after debt is paid off. The most important equation to remember is that
Assets (A) = Liabilities (L) + Shareholder’s Equity (SE)
The structure of the Balance Sheet is based on that equation. This example uses the basic format of a Balance Sheet:
With respect to the right side of the balance sheet, because companies can obtain resources from both investors and creditors, they must distinguish between the two. Companies incur debt to obtain the economic resources necessary to operate their businesses and promise to pay the debt back over a specified period of time.
This promise to pay is based on a fixed payment schedule and is not based upon the operating performance of the company. Companies also seek new investors to obtain economic resources.
However, they don’t promise to pay investors back a specified amount over a specified period of time. Instead, companies forecast for a return on their investment that is often contingent upon assumptions the company or investor makes about the level of operating performance.
Since an equity holder’s investment is not guaranteed, it is more risky in nature than a loan made by a creditor. If a company performs well, the upside to investors is higher.
The promise-to-pay element makes loans made by creditors a Liability and, as an accountant would say, more “senior” than equity holdings, as it is paid back before distributions to equity-holders are made.
To summarize, the Balance Sheet represents the economic resources of a business. One side includes assets, the other includes liabilites (debt) and shareholder’s equity, and Assets = L+E.
On the liability side, debts owed to creditors are more senior than the investments of equity holders and are classified as Liabilities, while equity investments are accounted for in the Equity section of the Balance Sheet.
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