Balance Sheet: Definition
Balance sheets show the financial position of the business by detailing the sources of funds and the utilization of these funds.
The technical name “balance sheet” is derived from the earlier practice of tabulating in a sheet debit and credit balances, which are carried forward after the books of accounts are closed after a specific period of business operations (usually a year).
Balance Sheet: Explanation
The balance sheet reflects the fundamental accounting model, which describes the financial position of a firm in terms of equality between its assets (A) on one side and its liabilities (L) plus owners’ equities (OE) on the other (A = L + OE).
Hence, “balance sheet” is a widely used term. However, it is somewhat less descriptive than the more appropriate designation “statement of financial position.”
Liabilities are the debts of the entity and other claims against its assets, which oblige the firm to provide goods and services. Usually, liabilities are measured at their current cash equivalent or the maturity value of the debt.
Owners’ equities (OE) are the residual amounts, A – L = OE, but they bear little resemblance to the current market value of an entity.
Let’s consider an example to illustrate the balance sheet and the terms used while preparing it.
John is a bookseller. His shop, called John Book Center, is located near a polytechnic, an intermediate college, two secondary schools, and two primary schools. He deals mainly in educational books and stationery.
John generally sells books only on a cash basis but occasionally extends credit to reliable customers, particularly if a school wishes to buy books in a significant quantity.
Similarly, John purchases books from his suppliers mostly on cash terms, but certain publishers offer him credit facilities.
John’s premises are rented, but all the furniture, fittings, and equipment in the shop are his own.
On 31 March this year, John estimated that:
- The value of unsold books and stationery in his shop was $37,250
- He was owed $6,140 by customers to whom he had sold books on credit
- His furniture and fittings (e.g., tables, chairs, bookcases, and shelves) were worth $12,400, his photocopier was worth $45,000, and his computer was worth $13,800
- He owed $19,500 to publishers from whom he had bought books on credit
- His cash box had $1,660 in it while the bank account that he operated under his shop’s name had a balance of $8,250 in his favor
- Two years ago, John started his business with a $100,000 loan from SME Bank Ltd. (half of this loan was still unpaid on 31 March)
The above information relating to John’s business unit, namely John Book Center, can easily be described as a sort of summary of its financial position on the given date (i.e., 31 March this year).
It shows what the company has, what it is owed, and what is owed by it to others. Let’s examine this in more detail.
Unsold books and stationery (i.e., the shop’s stock-in-trade), amounts owed to the shop by its customers (i.e., debtors), and cash in the till box are examples of the things of value that John Book Center owns and uses to conduct its affairs.
These “things” are called assets.
Every business unit must have assets to be able to conduct business. It is unthinkable for someone to be doing business without having anything to sell, anywhere to sell from, or anything to sell with.
Assets are, therefore, essential for the conduct of every business. Let’s now list John Book Center’s assets and find out their total value.
In addition to the above assets, it is possible that John has other personal assets (e.g., household items, personal vehicles, and cash in his personal bank account).
However, in this case, we are concerned only with John Book Center’s assets. Therefore, any asset not belonging to John Book Center, even if it belongs to John as a person, is to be ignored.
John Book Center owes some amounts to outsiders, namely $19,500 to its credit suppliers and $50,000 to SME Bank Ltd. Amounts owed by a business to outsiders are called liabilities.
While it is theoretically possible that a business unit may have no liabilities to outsiders, it is rare in practice for a business to transact all its affairs strictly on cash terms and, in this way, avoid having any liabilities.
Hence, almost all businesses have some liabilities at any given time. The total of John Book Center’s liabilities is $69,500.
3. Net Worth
It is apparent from the above that John Book Center’s total assets (worth $124,500) are greater than its total liabilities (amounting to $69,500) by $55,000. This amount represents the net worth of the business.
If, for example, all the assets at John Book Center are sold, a total of $124,500 will be realized. Out of this amount, the liabilities owed by the business unit must be paid ($69,500), leaving a net balance of $55,000.
The excess of a business unit’s assets over its liabilities at any given time is called its net worth. This fact can be easily shown in the form of the following equations:
Assets (A) – Liabilities (L) = Net worth (NW)
A – L = NW
NW = A – L
A = NW + L
L = A – NW
At this point, using the above facts and figures, we can prepare a balance sheet for John Book Center. This is because, at any time, a company’s assets, liabilities, and net worth can be arranged in the form of a balance sheet.
By definition, a balance sheet is a statement that shows the financial position of a business (or a person) at a given time, expressed in the terms of assets, liabilities, and net worth.
It is important to note that a balance sheet is a statement prepared at a particular time, and it is true only at that particular time. This is because the composition of a business unit’s assets, liabilities, and net worth change continuously.
For example, a minute after the above statement was prepared, a check may have been issued to one of the creditors, thereby reducing cash at bank (and total assets), as well as reducing the amount owed to suppliers (and, hence, total liabilities).
Later in this article, we will consider the impact made by different transactions on a firm’s balance sheet.
The Nature of Net Worth
The excess of a business unit’s assets over its liabilities represents its net worth. One may ask here: Who does the business unit belong to? The answer, you may say, is pretty obvious: To its owner, of course.
This is correct. So, we can say that because a business unit belongs to its owner, its net worth also belongs to its owner.
Another question that may arise here is: How does this net worth arise? In other words, how does a business come to have more assets than liabilities?
The answer to this question is also very obvious: It’s because the owner of the business has invested his personal funds in the business.
It follows, therefore, that the excess of a business unit’s assets over its liabilities actually represents the investment made in it by its owner or owners.
Any money invested in a business with a view to earning profits is called capital. The net worth of any unit is the excess of the value of its assets over liabilities. It belongs to its owner and is, therefore, equal to the owner’s capital.
At this point, we have two names for seemingly the same thing: net worth and capital.
Both are equal in amount, but their meaning is slightly different. Net worth is a term used in relation to a business unit’s position, whereas capital is a term used when referring to the owner’s interest in the business unit.
In the case of the above balance sheet, we can say that John Book Center has a net worth of $55,000, whereas John has a capital of $55,000 invested in John Book Center.
Let’s consider another example to further elaborate on the different meanings of net worth and capital.
Harry and Barbara started a business with the former contributing $50,000 and the latter $30,000 in cash. They also borrowed $40,000 from the Agricultural Development Bank (ADB).
From the total amount thus raised, Harry and Barbara purchased a piece of land for $100,000. The rest of the money has been deposited in the bank. Their business will be called H&B Fruit Growers and will mainly export citrus fruits.
The opening balance sheet for H&B Fruit Growers will appear as follows:
The net worth of the business unit (i.e., H&B Fruit Growers) is $80,000, which is the excess of the firm’s assets ($120,000) over its liabilities ($40,000).
At the same time, Harry has a capital of $50,000 and Barbara has a capital of $30,000 invested in H&B Fruit Growers.
In other words, H&B Fruit Growers’ net worth is also the total of the capital invested by the two partners, Harry ($50,000) and Barbara ($30,000).
While the two terms are often used interchangeably, it is more appropriate to say that H&B Fruit Growers has a net worth of $80,000 (not a capital of $80,000) and Harry has a capital of $50,000 (not a net worth of $50,000).
Similarly, Barbara is said to have a capital of $30,000 (not a net worth of $30,000) invested in H&B Fruit Growers.
Net worth as a term, therefore, applies to the business unit, whereas capital as a term applies to owners or the owners’ interest in the business.
In practice, it is common when drawing up a balance sheet to show the capital contributed by each owner separately (if there are more than one) rather than show only the business unit’s total worth.
In practice, the above balance sheet will, therefore, be drawn up as follows:
The Balance Sheet Equation
The balance sheet equation indicates the composition of a balance sheet. It was shown earlier in this article as:
Net worth = Assets – Liabilities
It can be restated as follows:
Capital = Assets – Liabilities
By rearranging the formula, we have:
Assets = Liabilities + Capital
Also, through further rearrangement, it follows that:
Liabilities = Assets – Capital
If two of the three figures making up a balance sheet are known, the third figure can be calculated using the balance sheet equation.
For example, if the assets of a business amount to $75,200 and its owner’s capital is $39,800, its liabilities can be computed as follows:
Liabilities = Assets – Capital
= 75,200 – 39,800
Similarly, if the liabilities of a business are $68,100 and its owner’s capital is $81, 900, its assets must be:
Assets = Liabilities + Capital
= 68,100 + 81,900
Remember, the balance sheet equation is always true; this is because a proper balance sheet always balances.
Uses of Balance Sheet
The balance sheet is one of the most prominent accounting reports. Various parties use it to obtain different types of information for their own use. Generally, the main uses of a company’s balance sheet are as follows:
- Enables the user to calculate the actual capital invested in the business
- Creditors and lenders can ascertain the financial position of the business
- Can help to determine the purchase condition of the business
- Different ratios can be calculated from the balance sheet, many of which are invaluable for managers
- The working capital trend of the business can be determined by comparing the balance sheets from successive years—corrective measures can be taken, where necessary
- Enables the user to ascertain the proprietary interest of a person or business organization
Specimen/Format of Balance Sheet
There are two main formats in which balance sheets are prepared.
Under this format, the left-hand side lists the liabilities of the business as on the last day of the accounting period as well as the details of its capital position. Various assets are listed on the right-hand side of the balance sheet.
Note 1: Assets of the same class are grouped together. All fixed assets are grouped and all current assets are grouped.
Note 2: The balance of the capital account is calculated as follows:
The vertical format merely involves rearranging the information shown in the horizontal format.
The vertical format clearly displays a network of the business to the owner (i.e., the capital). This format also shows the investment in fixed assets and working capital, which is the difference between the current assets and current liabilities.
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We hope this article has helped you come to grips with the fundamentals of balance sheets. We’ll be glad to assist if you need to know anything else about this topic or related ones.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.