The Balance Sheet

Understanding the Balance Sheet

Every business enterprise must have a balance sheet. A balance sheet shows:

· Assets

· Liabilities

· Shareholder's Equity

Whether you are a CEO, manager, or just starting your business career, you should know how to read and interpret a balance sheet.

If you are a banker, and a company comes to you or a loan, how do you determine if the company is a good risk? If you were an investor you would want to know the company’s financial condition before you bought its stock. If you wanted to buy stock as an investor, you would want to know the companies value.

You need the Income Statement to determine how the business is doing. What are the sales and expenses, and is the enterprise making a profit.

Another tool is the Balance Sheet, or statement of financial position. It is a snapshot of the organization's worth at a given point in time.

The Assets on a balance sheet include:

· Cash

· Accounts Receivable

· Inventory Value

· Equipment Value

· Building Value

Say that this totals $245,000 for a particular business.

The Liabilities on the balance sheet include:

· Accounts Payable

· Notes Payable

· Mortgage

· Accrued Taxes

Say that this totals $200,000 for a particular business.

The difference between Assets and Liabilities is the Owner's Equity, or, if it is a Corporation, it is the Shareholder's Equity.

In this example:

$245,000 Assets

-$200,000 Liabilities

$ 45,000 Shareholder's Equity

This is the Shareholder's (or Owner's) interest, or claim on Assets.

Accountants have an equation for the Balance Sheet:

Assets = Liabilities + Owner's Equity

The example above shows that the Owner's could take $45,000 as cash. But this is not how most businesses run. What is standard is for this cash to be distributed among various accounts in order to run the business.

In theory if a company sells all of its assets and pays off all of its liabilities, the difference would be the cash value of the company. But this doesn't consider the Intangibles, such as:

· Trademarks

· Patents

· The Goodwill of its Name

· The Share of the Market it has

When cash is put into a business, it is counted as an asset. When some cash is transferred to inventory, then the value of inventory increases and the cash reserve decreases. When the inventory is sold then inventory reduces, and the cash reserve increases when the sale of the inventory is realized. The difference is credite4d to owner's equity.

This process of debiting and crediting is known as Double Entry Bookkeeping, and is the basis of Accounting.

Its premise is based on the idea that if a transaction is made in one account, at least one other transaction will be made in another account.

For example, if a customer pays a bill, the accounts receivable account decreases, and the cash category increases. It is BALANCED.

Another example, if a mortgage payment is made, the cash account decreases and the loan obligation decreases. It is BALANCED.

All transactions are initially recorded in the General Ledger. Then they are recorded on two other sets of summary figures, to show the financial status and operating record of the company. One is the Income Statement; it records all transactions involving Revenues and Expenses. The other is the Balance Sheet, which is the summary record of all the assets and liabilities at a given moment; ad shows the company's net worth.

A Balance Sheet shows a company’s net worth. Some items are estimated on the Balance Sheet. They may have a known value when originally acquired (like a new car), but each year it will depreciate, thus is it worth less, until it is obsolete.

Some items on the Balance Sheet are known: Cash, Loans, Accounts Payable. Some items, like Accounts Receivable, may not be clear, as some receivables may not get paid to you.

Assets on a Balance Sheet are usually listed according to their liquidity, or, how fast they can be converted to cash. In order...

· Cash

· Market Securities

· Accounts Receivable

· Inventories

· Equipment and Machinery

· Land and Buildings

"Current Assets" are those assets that are expected to be used up in a year, or in the operating cycle of the business, that is, the time it takes to convert cash into inventory and then to sales and then back into cash.

Prepaid expenses are assets because payment is made in one accounting period for an item to be used in another accounting period.

Fixed assets can be harder to judge as to their present worth. Equipment may be worn out or obsolete. Land may not be as valuable as when first bought due to inflation. When valuing land or buildings, take the first year value as the value, that is, what you paid. Thereafter, the formula is Value = Cost - Depreciation.

Vehicles may be depreciated over 5 years, but land and buildings may be depreciated over a 20 year periods as it will last longer. Depreciation is the write off of value over time for tax purposes.

Depletion is the exhaustion of natural resources. This would be used for such business as mining companies.

Amortization is the cost allocation of an intangible asset. It is handled similarly to depreciation and depletion. A patent is an intangible asset and its value is based on the cost of acquiring it. A patent good for 20 years will have a value based on the cost of acquiring the patent.

Goodwill is an intangible asset and is not used often. What it is would be the difference between what the buyer pays for the company, and what the buyer actually received in assets. If Goodwill is an asset, it has been decided that the reputation of the company and its know-how are worth more than the physical assets.

The next major block on a Balance Sheet is the Liabilities. "Current Liabilities" are those liabilities expected to be paid within one year. "Long Term Liabilities" are those that will be paid in a time frame greater than one year.

Current Liabilities:

· Accounts Payable

· Notes Payable

· Accrued Taxes

· Accrued Interest

Long Term Liabilities:

· Loans on Equipment

· Mortgage on Building

· Deferred Income Taxes

Accounts Payable is the bills for raw materials, wages, utilities, etc.

Notes payable are short term loans (like from a bank).

Accrued taxes are those withheld but not due. (Example: payroll taxes taken out at month's end but not due until the second day of the following month. To complete the balance sheet for the current month, those taxes withheld but not yet paid would be "accrued.")

Accrued Interest would be interest expense used but not due. (Example: A company pays $600 of interest on a loan once a year. The monthly interest not paid is accrued and is a liability.)

Debentures are fixed interest securities issued by a company in return for long term loans.

Mortgages are secured by the land or building. Debentures are secured only by the reputation of the company.

The last section on the balance sheet is Owner's Equity. Two types of stock are used to raise capital: Common and Preferred.

Preferred stock is listed first, and holders of this kind of stock are given first preference in dividends paid. If a company was to liquidate, holders of preferred stock would have a claim on assets before holders of common stock.

Common Stock is securities that represent an interest in a company.

________

The tricky things on a balance sheet are to value assets properly. If inventory is valued at $100,000, but $15,000 is obsolete, the real value of the inventory is $85,000.

The basic procedure of accounting is NOT an exact activity. GAAP discusses how to value and depreciate assets - and they can vary. The quality of the Balance Sheet is determined by the accurate, realistic, conscious, deliberate work of the accounting process. This leads to proper valuation and provides the best picture of the financial health and status of a company. Do the best you can to identify assets, their proper elements and measurements.

Questions

1. Cash is in what category on the balance sheet?

2. Would a bond payable be considered an asset or a liability?

3. The inventory of a company is considered a what?

4. A company's patent or its goodwill is what type of asset?

5. When a company prepays an insurance premium what category is it found under?

6. Land and buildings are what types of assets?

7. Are accrued taxes an asset or a liability?

8. Where on the balance sheet would Common Stock be found?

9. True or False: An advance from a customer would be recorded as a liability?

10. True or False: The balance sheet can be called the statement of financial position.

11. Current Liabilities are those obligations that are to be paid within one year.

12. A treasury note is a fixed asset.

13. True or False: Assets are usually recorded at actual cost on the balance sheet.

14. True or False: Owner's Equity is equal to the net assets of the company.

Answers

1. Assets

2. Liability

3. Asset

4. Intangible

5. Current Assets

6. Fixed Assets

7. Liability

8. Shareholder's Equity

9. True

10. True

11. True

12. False (it is a Current Asset)

13. True

14. True