September 02, 2020

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The Balance Sheet Basics

The Balance Sheet Basics

Accounting is the language of business. Business owner/s, investors or any interested parties can understand that business by looking at the accounting reports. There are tons of accounting reports, the two main accounting reports that are the biggest picture reports and are required if you want to buy or sell a business, get a loan, or do anything having to do with the monetary value of a business are the Profit & Loss Statement and the Balance Sheet. In this article, we will explore the second one. 

What is a Balance Sheet?

Balance sheets may be less exciting than profit and loss accounts but they contain vital information for investors and help to assess the business risk. The Balance Sheet tells the value of a particular company. A simple way to explain it is your bank account. Does your bank tell you how profitable you are? It gives you the value of your bank account. Moreover, you can only look at the value of your bank account on any given day.

You would look at your bank account balance value at a certain moment in time in order to know what the value of your bank account is. This is exactly what a Balance Sheet does, only it represents the whole business. If, on the other hand, you wanted to know your profitability, you would look at the deposits and withdrawals over some time. This is where an Income Statement would come in.

Example Balance Sheet

As you can see from an illustration below, the reports are always structured the same. The business name goes first, the name of the statement second, and for a Balance Sheet, we would insert the date that this Balance Sheet is for – as of XYZ date. The Balance Sheet has three sections: Assets (things we own) = Liabilities (things we owe) + Owner’s Equity. Thus, this statement represents the accounting equation. As you can see from the report, the total Assets ($) and the total Liabilities & Owner’s Equity are the same. 

The Balance Sheet Basics

Balance Sheet Structure

Now, let’s take a closer look at these accounts. One concept you need to be aware of is the short term and long term: something is short term if it has to do with less than a year, and things are long term if they are more than a year. With Assets, we have Current Assets (short-term). These are listed in the order of liquidity, which is how quickly it can become cash. 

  • Bank balance – represents cash you own on a given date. 
  • Accounts Receivable – money customers are going to pay for the work already done or goods already received, which you recorded as revenue on your Income Statement. You have done everything you needed to do to earn that money and are just waiting for them to pay you. 
  • Pre-paid Expenses – what happened here is that you paid money from your bank account on expenses, but you cannot deduct those expenses yet on your Income Statement. Instead, you record it here until it will be moved to the Income Statement because you technically have that value in your business – that other company has not earned your prepaid expenses yet and would have to give it back if they do not fulfill their promise. 
  • Inventory – inventory would take the longest to turn into cash, so it is listed last. 

Next, you have Fixed Assets, which represent any asset that has a life of more than a year and you plan to use it for more than a year. These are things like building, office furniture, and equipment of any kind. Fixed assets remain on your books on your purchase cost basis. Your business also gets to take a depreciation expense to deduct fixed asset cost over time. This depreciation is represented as a total depreciation expense to date and reflected as an Accumulated Depreciation. This amount will reduce the total amount of Fixed Assets.

Next, you have a section for Liabilities. As with Assets, it is subdivided into long-term items and short-term items. The Current Liabilities section usually has items like:

  • Unearned Revenue – these are items that customers paid you in advance. In this case, you have a liability to perform whatever you do to earn that money. 
  • Accounts Payable – these are money your business owes to vendors for items or services bought on credit.
  • Short-term Loans – these are loans your business took, but unlike mortgages, it has to repay them within a year. 

Any liabilities, such as Working Capital Loan or Mortgage, that you will have to pay over a longer period will be written under the long-term section.

Finally, the Owner’s Equity would have your Retained Earnings account and Owner’s Capital account. The Retained Earnings account reflects earnings that the company has made to date, so it is an accumulated account. This is how the Income Statement gets to the Balance Sheet. 

Any money that the owner or shareholders put into the business and any money that they take out of the business will be tracked in the Contributions and Draw accounts and the total will be represented on the Balance Sheet under Owner’s Capital.

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Author: Charles Lutwidge

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