Understanding Balance Sheets in the Simplest Way | Article – HSBC VisionGo

Financial health is deduced when the total assets equal shareholders’ equity and total liabilities.
Legal  ·    ·  3 mins read

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If you have a business or are working for one, you probably have scanned through the annual report. If you have not done that, no problem! Balance sheets are a vital component of company financials and help determine the financial health and status of the business.

At the outset, a balance sheet is broken into three sections - reported assets, liabilities and equity. Doing so will help you understand the balance sheet in an easier way. These categories will give you insights into what the business owns, how much it owes at a point in time. The operative word here being “at a point in time”. Some of you might be overwhelmed by this. There is no need to worry. All you need is a go through and get a grasp of basic concepts. In the end, you will be reading balance sheets like a professional. 

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What is a Balance Sheet?

Also referred to as a “statement of financial position”, a balance sheet reflects the value of a business or corporation. It is an exhibit that consists of assets, liabilities and owner’s equity - or net worth - on a particular date which is most probably the reporting date. The balance sheet should not be read in isolation. It goes hand-in-hand with two other statements, the income statement and the statement of cash flow. More so, the financial statements require the assistance of proficient accounting experts. 

More often than not, a balance is prepared and distributed monthly or quarterly. However, it is subject to and depends on the company statute or law of financial reporting. 

What purpose does a Balance Sheet serve?

The balance sheet helps the owner, investor - or shareholder - understand and decipher the financial health of their venture, including what the company owns and owes. 

What makes the crux of the balance sheet?

The crux of the balance sheet is in its name; it should always tally. A balance sheet is divided into two portions such as they equal each other through the formula:

Assets = Liabilities + Shareholder Equity

When the right-hand side equals the left-hand side, a balance sheet is considered balanced and appropriate. In simple words, business assets should match the financial obligation and equity investments and retained earnings. More so, a balance sheet offers a snapshot of the financial position at a specific point in time. Assets, liabilities and shareholder equity sections of the balance sheet reveal the value on that particular day and not over a period.

Key terms that make the balance sheet

The section offers a breakdown of the three broad or umbrella categories - assets, liabilities and shareholders’ equity. 

Assets

An asset is something valuable that the business owns and possesses. Within the realms of the balance sheet, the asset is considered positive and segregated into current assets and noncurrent assets. 

Current Assets

These are assets having a lifespan of less than a year, after which they typically convert into or are sold for cash. The current assets include cash and cash equivalents, inventory, prepaid expenses, accounts receivable and marketable securities.

Noncurrent Assets

These are assets that have a lifespan that extends beyond one year. Noncurrent assets are long-term investments and not converted into cash within a year. They include tangible and intangible assets such as land, machinery, buildings, computers, intellectual property, patents, trademarks, brands, goodwill and copyright. 

Liabilities

At the subsequent end of the gamut, there are liabilities. Think of liability as the opposite of an asset. As is mentioned above, an asset is a valuable item owned by a business, whereas a liability is an item that the firm owes to other parties.  

Liabilities are financial obligations that a company owes to other parties; for instance, a legal imperative that requires a company to pay money to a debtor. These are considered negative in the balance sheet tally. Like assets, liabilities come into two categories - current and noncurrent. 

Current Liabilities

These are liabilities that a business must pay within one year. The short-term liabilities include payments to employees such as salaries, utility payments, rent, account payables, debt financings such as overdrafts and other accrued expenses.

Noncurrent Liabilities

These are liabilities that extend beyond one year, after which a business is to pay them. They are long-term liabilities. They include lease payments, bonds, loans, tax liabilities, pension, hire purchases and others. 

Note: Categorising loans and hire purchase

Loans can be split into current and noncurrent liabilities. For instance, the interest and capital payments due within one year can come under current liabilities. The remaining portion that is payable after one year shall then come under noncurrent liabilities.  

Shareholders’ Equity

Alternatively referred to as owners’ equity, shareholders’ equity is the company’s total net worth. It includes the initial capital raised by the owner through his or her investment in the business. The net profit forms part of the shareholders’ equity. When a corporation reinvests the net profit at the year-end, it becomes known as retained earnings. 

Worked Example

1. Assets:

Cash - $2250, Accounts receivable - $5500, Inventory - $1100

Total assets - $8850

2. Liabilities:

Accounts payable - $375, Wages payable - $1400

Total liabilities - $1775

3. Equity

Common stock - $4000, Retained earnings - $8500, Drawing - $5425

Total equity - $7075

Now, applying the formula, 

Assets = Liabilities + Equity

$8850 = $1775 + $7075

Final Comments

The information and insights rendered by balance sheets are crucial in gauging the financial health of a business. Balance sheets help deduce whether the firm is struggling or thriving. With that said, the balance sheet contents are vital for leaders and investors, including prospects, to comprehend the business’s financial and market standing. It is an important skill, and all business owners should learn the basics.

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