While business owners and management may not have an extensive accounting and financial background, it is important to understand how to read the most common types of financial statements. The three statements used most commonly are the balance sheet, the income statement, and the cash flow statement. For the rest of this post, we are going to focus on the balance sheet.
A balance sheet can be thought of as a snapshot of the company’s financial position at a specific point in time. One of the first things you are taught in accounting class is the basic equation for the balance sheet:
Assets = Liabilities + Equity
To start understanding how to read the balance sheet, we first need to define each component of this equation:
- – Assets are something that the company owns and that has value. The most common examples include Cash, Inventory, Accounts Receivable, and Equipment.
- – Liabilities are obligations of the company that will result in future outflows. The most common examples include Accounts Payable, Accrued Expenses, and Debt.
- – Equity is the investment in a company. It is the difference between assets and liabilities, which represents what is “left over” in the company. Common classifications of equity are Stock, Additional Paid-in Capital, and Retained Earnings.
Now let us look at a simple example. Rachel decides to start ABC Manufacturing Company, which manufactures and sells widgets. To fund the business, Rachel puts $10,000 of her own money into the company by depositing it into a company bank account, and she borrows $10,000 from a lender and deposits the borrowings into the company bank account. The $20,000 of cash in the bank account is an asset. The company owns that cash, and of course cash has value. The $10,000 of debt that the company owes to the lender is a liability. It is an obligation of the company that will have to be paid back at some point in the future. The difference between those two amounts, $10,000, is equity. It is Rachel’s ownership interest in the company. Going back to our original equation, we can see that:
Assets = Liabilities + Equity
Cash ($20,000) = Debt ($10,000) + Equity ($10,000)
The following is an example of what a balance sheet looks like when presented as a financial statement.
As you can see from the example, the balance sheet is broken into three parts. The first part is the company’s assets, and the second and third parts are the Company’s Liabilities and Equity, respectively. Going back to the original equation, we can see that in the sample balance sheet, total assets of $120,000 is equal to total liabilities and equity of $120,000. To help better understand the balance sheet, we can review some of the common balance sheet items and the transactions that lead to those balances.
Accounts Receivable: These are amounts owed to the company from customers. When the company sells a widget and the customer does not have pay for the widget for 30 days, at the time of sale the company will increase their Accounts Receivable and increase Revenue. Revenue is an Income Statement item, which we will discuss in a future article. But all Income Statement items will flow to the balance sheet through Retained Earnings. Therefore, when we make a sale, we are increasing Accounts Receivable (Asset) and increasing Retained Earnings (Equity). When the customer pays the company the amount it owes for the purchase of the widget, on the balance sheet Accounts Receivable (Asset) will decrease and Cash (Asset) will increase. Notice how in this last example, both items that change are assets. A transaction does not have to impact both sides of our original equation, rather the equation just has to balance.
Inventory and Accounts Payable: If our company sells widgets, it may need to buy raw materials that are then assembled to make the final widget that is sold. Those raw materials, and eventually the finished goods, are Inventory. If we purchase the raw materials from a vendor and they allow us to pay in 30 days, then we have created an Accounts Payable. Going back to our original equation and definitions, the company has now increased Inventory (Asset) and increased Accounts Payable (Liabilities). Inventory is an asset because the company owns the materials and it has value. Accounts Payable is a liability because the company owes the vendor for the purchase it made, meaning it represents an obligation that will result in a future outlay by the company. When the company pays the vendor, it will reduce Cash (Asset) and reduce Accounts Payable (Liability). When the company assembles and sells the widgets, it will reduce Inventory (Asset) and increase Cost of Goods Sold. Like Revenue, Cost of Goods Sold is an Income Statement Account. Since Cost of Goods Sold is an expense of the company, it reduced the company’s income, which flows through to the balance sheet as a reduction of Retained Earnings (Equity).
Once we have basic understanding of the balance sheet, we can start to build on those fundamentals and use it as a valuable tool to drive profitability. In future articles we will dive into how to analyze the balance sheet and perform ratio analysis. Please let us know if you have any questions or would like to see specific topics addressed in the future.