The Anatomy of the Balance Sheet

Understanding a the Balance Sheet

The Anatomy of a Balance Sheet

In our previous post we examined, from a high-level, the anatomy of an Income Statement. We move along today to examine the anatomy of the Balance Sheet.

Not to trivialize the importance of the Balance Sheet, but at its core, a balance sheet provides us a look into the balances of certain accounts. It is, as its name suggests, a representation of account balances. In accounting for a business there are many accounts. There are bank accounts, accounts for tracking invested monies, expenses, credit cards, loans, taxes owed, monies owed to us, and the list goes on.

From a bird’s eye view, the Balance Sheet tells us about the business’ assets (what it owns), its liabilities (what it owes), and the amounts of owner/shareholder equity (how much has been personally invested into the company).

Thinking about these three key areas (assets, liabilities, and equity), we can take a deeper look into what drives these final values (balances) and how they affect, or reflect, the financial health of a business.

Assets can be thought of as “things” that a business owns. So if a business owns a building, land, equipment, a vehicle, etc. these would be considered assets. Additionally, if the business has a checking, savings, or investment accounts these are also assets. These types of assets are those that we can touch or feel - physical assets - which are often referred to as “tangible assets”. Other types of assets might include assets which are “intangible”. Intangible assets are things like intellectual property. These types of assets are not physical - we cannot physically touch them. For example, a business might hold a patent or copyright or they may own some proprietary software or process which has monetary value - and can be monetized by selling the [intangible] asset.

Liabilities can be thought of as money that the business owes. In a business the purchase and acquisition of many items is performed with cash. Many regularly occurring expenses such as rent, utilities, office supplies, etc. are frequent enough that they are paid for, in full, on a monthly basis. Those are expenses. Liabilities are a little different. Liabilities are monies that the business owes for something that it has acquired and it might take longer than a month or so to repay. Examples of liabilities are a vehicle loan, property or building loan, equipment loan, or a loan from an investor or partner. There are many types of liabilities. Some liabilities are paid back in a relatively short period of time, say 30-90 days, while others are long-term and can extend upwards of 1-30 years or more. When thinking about these liabilities we can categorize them by the length of time in which they must be repaid and we can even itemize them by the entity to which the money is owed.

Equity is the amount of money that the owners/investors of the business have personally given (invested) into the business. So when a business owner decides to transfer $5,000 into their business account to purchase supplies or aid in the operation of their business, this is an equity investment. In a business it is important to track the amount of money (equity) an owner/investor/shareholder puts into the business because eventually they would like to recuperate their investment. In some business models, the business is funded by partners or investors. In such cases, these parties are considered shareholders and they do so with the sole intention of not only recuperating their initial investment, but in hopes to earn additional financial returns as the business grows and produces a profit. More on that in a different post.

Okay, so we now know that the Balance Sheet communicates to use three different, but very important pieces of information: what the business owns, what the business owes, and how much has been invested by its shareholders/owners. This information can be very useful when trying to understand the overall financial health of the business at any point in time. Think about it, business “A” has $50K in assets, but has $100K in liabilities while business “Z” has $25K in assets but zero in liabilities. Just looking at those numbers alone, if you are considering the risk of lending each of these two companies money, which seems more appropriate to lend to? The one who already has $100K in outstanding debt or the one who has no debt? I am not trying to diminish the other variables that go into the decision of loaning a business money, but I am trying to communicate how these numbers can be used and understood. To take it a step further, and include equity if business “A” has an owner equity balance of $500K and business “Z” has an owner equity balance of $50K, we can clearly see that business “A” has a lot more to lose in the event of a business failure. In other words, the stakes are much higher for business “A” and a loss could truly be great for its shareholders.

Summary

The Balance Sheet provides insight into what a business owns, owes, and how much has been invested into it. Oftentimes, key financial decisions can be made by examining the line items of the balance sheet. The Balance Sheet offers us a clear view of the financial position of a business at a particular point in time. This information can be used by owner/shareholders, and current or potential investors and lenders to decide if they should invest in the business.

In our next post, we will examine the Anatomy of the Statement of Cash Flows