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Balance sheet Basics

Posted on June 8th, 2017 by Sanjit Anand |Print This Post Print This Post |Email This Post Email This Post

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To undestand this take a example from Individual to Business.

If you want to consider your own financial situation ,then three things you will consider :

  • How much is owns
  • How much is owes

and, these two makes how much is your net worth.

net worth =owns - owes

or

owns =owes +net worth

So you have two major category, if I ask you what are things which you consider then you might be able to list down few as

  • own simply means : cash in bank, some big asset like house, car and any other property like Stock, or may be your PF and CPF or 401(k) account that you are going to claim.
  • The "owing" simply means your mortgage, car loan, credit card balance and any other debt.

with this simple equation you can able to find your net worth. Sound good:)

so now move this understanding in business world.

In business world, there is slighly change in the understanding:

  1. What the company owns is called it assets
  2. What it owes is called it liabilitties
  3. What it's worth is called owner's equity or shareholder equity.

combining you will get asset-liabilities= owner's equity

or

asset = liability +owner's equity

if you recall this is what called fundamental of accounting equation.This latter formulation reflects the two sides of the balance sheet: Asset on the one side , liability and owner's equity on the others. The sum on the side has to equal the sum on the other side, that means Balance sheet has to balance.

 

Do you know the reason of Balance sheet Balance

in above example you have seen company balance sheet just in the same way you'd look a indivual's net worth.

Net worth has to equal what you owns minus what he owes, beacuse why net worth we called as "individual", which is same for a business.

Now take a look at what the balance sheet shows.

Take a example

Lets take a example , a company is being started with initail investment of 50000 to run the business , the investor is consider as owner . So he has 50000 in cash on the assets side of the balance sheet . At this point he does not have any liabilities, therefore he has 50000 in the owner's equity. so this stage balance sheet is balances.

Now , the company buy a vechile for 36000 in cash, if nothing else changes - and if you construct the balance sheet at this stage after the vechicle transaction, then the asset side of balance sheet looks like:

Asset

--------------------------------

  • Cash 14000
  • Property , Plant and equipment (36000)

it still adds up to 50000 - and the other side of the balance sheet, he still has 50000 worth in owner's equity. What you can see , the balace sheet is still balanced.

now the owners decided he need to expand his business and to do this he need some money , so he approch bank and taken a loan for 10000. This 10000 amt borrowed from bank , raise his total cash to 24000(14000 earlier +10000 bank loan), then One side of Balance sheet looks like

Asset

--------------------------------

  • Cash 24000
  • Property , Plant and equipment (36000)

thats makes a total of 60000. He has incresed his asset, but the same time he also increase his liabilities as well, this 10000 he need to pay in near future , as this is liablity for him. So the other side of the balance sheet looks like

Liabilties and Owner's Equity

--------------------------------

  • Bank Loan 10000
  • Owner's equity 50000

Thats also makes the other side 60000,the only thing you noticed is owner's equity remain unchanged throughout all these transactions. Nornally owner's equity only affected when a company takes fund from its owners and pays out the money to owners or record a profit or loss.

Therefore as long as you remember the fundamental fact the balance sheet always balanced.

dgreybarrow Balance sheet normally assessing a company's health

It will decide the company is solvent or not ? if asset outweigh its liability, so that owner's equity is a positive number?

Can company pay its bills? This will be decided on current asset, particulaly cash compared with current liabilities.

How owner's equity been growing over time ? a comparision of Balance sheet for a period of time will show whether the company is doing good or not?

If you are doing some investment in company stock, then as investor you need to have much more detail examnination of Balance sheet and some of the foot note that you always find.

 

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