The balance sheet shows the financial position of the firm at a point in time. The left side of the balance sheet (called the debit side) shows the resources of the company (assets), whereas on the right side (or, credit side), it shows how these resources have been funded. By definition, the funding is either by the owners (equity) or by others (liabilities).
Asset: economic resources (with future value), or, things worth money.
Liability: an obligation resulting from a past transaction to pay money, render services, or deliver goods.
Equity: funding by the owners, or ‘residual claim’ (to the assets), which always equals total assets minus total liabilities.
Balance Sheet Example
The assets of the fictitous company ABCD Inc. (which is also used later) on January 31st, 20X0 consist of cash and equipment, 41,500 in total. This amount has been funded with 400 liabilities, and 41,100 equity. The equity consists of 40,000 paid-in capital, which is the amount of money raised by issuing shares. Retained earnings of 1,100 is the total of profits that have not (yet) been paid out as dividend.
For corporations the amount raised by issuing shares is presented separately from the profits retained in the company. For sole proprietorships – a business owned and ran by a single individual with no separate legal entity for the business – paid-in capital and retained earnings are not shown separately. Instead, these items are added and labeled ‘capital’.
Liabilities and equity are a means to attract capital for funding of assets. More debt or equity means that the firm can buy more assets. Conversely, paying accounts payable, repaying a loan, buying back shares or paying out a dividend decreases the assets. The optimal amount of debt and equity, as well as the optimal mix between the two is outside the domain of financial accounting.
Since the balance sheet shows the assets and the funding of the assets (liabilities and equity) at a point in time, it is not possible to infer the performance of the firm from the balance sheet. This is because performance is measured over a period. The income statement and the cash flow statement are used for this purpose (discussed later).
Balance Sheet Explained
– the balance sheet shows the financial position at a point in time (a financial ‘snapshot’)
– the accounting equation states that the value of the resources (assets) always equals total funding of these assets (liabilities and equity)
– it is not possible to infer a firm’s profitability from (the) balance sheet(s)
– assets are usually understated relative to the market value, whereas liabilities are not (or to a lesser extent), as a result, equity is usually understated (as equity is defined as the difference between the understated assets and total liabilities)