A balance sheet is a financial statement that lists a company’s assets, liabilities,and equity balances as of a specific date. The balance sheet is connected to a firm’s income statement, and statement of cash flows, which combine to show the full picture of a businesses finances.
Balance Sheet Components
The three components of the balance sheet are driven by the balance sheet formula:
Assets – liabilities = equity
A balance sheet provides detail for each of these categories:
- Assets: Assets are defined as resources that are used to generate revenue (sales) and profits in the business. An asset may be tangible, such as a vehicle, or intangible, such as a patent or other intellectual property.
- Liabilities: Liabilities represent amounts owed to other parties, including accounts payable and long-term debt.
- Equity: Equity (also referred to as stockholder’s equity) is the difference between assets and liabilities, equity includes common stock, additional paid-in capital, and retained earnings. The equity balance is the true value of a business.
The balance sheet formula must stay in balance, regardless of the number of transactions posted, or the dollar amount of accounting activity.
An Example Transaction
Here is a transaction that illustrates how the balance sheet formula is kept in balance.
Assume, for example, that a firm sells $20,000 in products to a customer, and that the customer pays $5,000 when the products are received. The accountant would post this journal entry:
Accounts receivable is an asset account, and the balance represents money that is owed by clients. Both accounts receivable and cash are asset accounts, and they are increased with a debit entry.
The firm also posts revenue, which is increased with a credit. Revenue less expenses equals net income, and net income is posted to equity. As a result, an increase in revenue also increases the equity account.
Here is the transaction’s impact on the balance sheet equation:
$20,000 increase assets – No change liabilities = $20,000 increase equity
Connection to the Income Statement
The income statement is connected to the balance sheet through the net income account. An income statement is generated using the income statement formula, which was used to post the transaction just above:
Revenue – expenses = net income (profit)
Income statement accounts are referred to as temporary accounts, because the account balances are adjusted to zero at the end of each month and year. Balance sheet accounts, however, are permanent accounts, and the ending balances are carried forward from one month to the next.
Assume, for example, that you own a furniture manufacturing business, and that you have these financial results at the end of February:
$300,000 Revenue – $260,000 expenses = $40,000 net income
At month-end, the accounting books are closed, and all revenue and expense accounts are adjusted to zero. The net impact of the income statement activity ($40,000) is posted to net income in the balance sheet.
The Cash Connection
The balance sheet is also connected to the statement of cash flows, which reports the change in cash for a specific time period. The cash flow statement separates cash inflows and outflows into operating, investing, and financing categories.
For example, the ending balance in the cash flow statement for the period ending May 31st must agree to the cash balance in the May 31st balance sheet.
Current vs. Non-Current
Assets and liabilities are either current or non-current. A current asset represents cash, or an asset that will be converted into cash within 12 months. Accounts receivable balances and inventory are current assets.
Accounts payable are bills you must pay within 12 months, and they are considered current liabilities. Long-term debts, however, are non-current liabilities.
Fixed assets, such as machinery and equipment used in a business, are non-current assets, because they will be used for years to generate revenue.
Liquidity vs. Solvency
The balance sheet is used to generate many financial ratios to make business decisions, and two important concepts for analysis are liquidity and solvency.
Liquidity measures a firm’s ability to produce enough current assets to pay current liabilities in the short term. The term solvency, on the other hand, refers to a company’s ability to generate enough sales and profits to purchase expensive assets and pay down debt over the long term. Financially healthy businesses must address both liquidity and solvency.