The purpose of the balance sheet is to look at what the business owns and owes on a specific date. By seeing what a business owns and owes, anyone looking at a balance sheet can tell the relative financial position of the business at that point in time. If the business owns more than it owes, it is in good shape financially.
On the other hand, if it owes more than it owns, the business may be in trouble. The balance sheet is the universal financial document used to view this aspect of a business. It provides this information by laying out the value of the assets and the liabilities of a business. One of the most critical financial tasks that a small business owner must confront is keeping track of what the business owns and owes. Before the business buys or sells anything or makes a profit or loss, the business must have some assets.
The assets of a business are anything that the business owns. These can be cash on hand or in a bank account; personal property, like office equipment, vehicles, tools, or supplies; inventory, or material that will be sold to customers; real estate, buildings, and land; and money that is owed to the business. Money that is owed to a business is called its accounts receivable, basically the money that the business hopes to eventually receive. The total of all of these things that a business owns are the business’s assets.
The liabilities of a business are anything that the business owes to others. These consist of long-term debts, such as a mortgage on real estate or a long-term loan. Liabilities also consist of any short-term debts, such as money owed for supplies or taxes. Money that a business owes to others is called its accounts payable, basically the money that the business hopes to eventually pay. In addition to money owed to others, the equity of a business is also considered a liability. The equity of a business is the value of the ownership of the business. It is the value that would be left over if all of the debts of the business were paid off. If the business is a partnership or a sole proprietorship, the business equity is referred to as the net worth of the business. If the business is a cor¬poration, the owner’s equity is called the capital surplus or retained capital. All of the debts of a business and its equity are together referred to as the business’s liabilities.
The basic relationship between assets and liabilities is shown in a simple equation:
Assets = Liabilities
This simple equation is the basis of business accounting. When the books of a business are said to balance, it is this equation that is in balance: the assets of a business must equal the liabilities of a business. Since the liabilities of a business consist of both equity and debts, the equation can be expanded to read:
Assets = Debts + Equity
Rearranging the equation can provide a simple explanation of how to arrive at the value of a business to the owner, or its equity:
Equity = Assets – Debts
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A basic tenet of recordkeeping is that both sides of this financial equation must always be equal. The formal statement of the assets and liabilities of a specific business on a specific date is called a balance sheet. A balance sheet is usually prepared on the last day of a month, quarter, or year. A balance sheet simply lists the amounts of the business’s assets and liabilities in a standardized format.
On a balance sheet, the assets of a business are generally broken down into two groups: current assets and fixed assets. Current assets consist of cash, accounts receivable (remember, money that the business intends to receive; basically, bills owed to the business), and inventory. Current assets are generally considered anything that could be converted into cash within one year. Fixed assets are more permanent-type assets and include vehicles, equipment, machinery, land, and buildings owned by the business.
The liabilities of a business are broken down into three groups: current liabilities, long-term liabilities, and owner’s equity. Current liabilities are short-term debts, generally those that a business must pay off within one year. This includes accounts payable (remember, money that the business intends to pay; basically, bills the business owes), and taxes that are due. Long-term liabilities are long-term debts such as mortgages or long-term business loans. Owner’s equity is whatever is left after debts are deducted from assets. Thus, the owner’s equity is what the owner would have left after all of the debts of the business were paid off. Owner’s equity is the figure that is adjusted to make the equation of assets and liabilities balance.
Let’s look at a simple example: a basic sales business.
Smith’s Gourmet Foods has the following assets: Smith has $500.00 in a bank account, is owed $70.00 by customers who pay for their food monthly, has $200.00 worth of food supplies, and owns food preparation equipment worth $1,300.00.
These are the assets of Smith’s Gourmet Foods and they are shown on a balance sheet as follows:
Cash $ 500.00
+ Accounts owed to it $ 70.00
+ Inventory $ 200.00
+ Equipment $ 1,300.00
= Total assets $ 2,070.00
Smith also has the following debts: $100.00 owed to the supplier of the food, $200.00 owed to the person from whom she bought the food equipment, and $100.00 owed to the state for sales taxes that have been collected on food sales. Thus, the debts of Smith’s Gourmet Foods are shown as follows:
Accounts it owes $ 100.00
+ Loans it owes $ 200.00
+ Taxes it owes $ 100.00
= Total debts $ 400.00
To find what Smith’s equity in this business is, we need to subtract the amount of the debts from the amount of the assets. Remember: assets – debts = equity. Thus, the owner’s equity in Smith’s Gourmet Foods is as follows:
Total assets $ 2,070.00
– Total debts $ 400.00
= Owner’s equity $ 1,670.00
That’s it. The business of Smith’s Gourmet Foods has a net worth of $1,670.00. If Smith paid off all of the debts of the business, there would be $1,670.00 left. This basic method is used to determine the net worth of businesses worldwide, from the smallest to the largest: assets = debts + equity, or assets – debts = equity. Remember, both sides of the equation always have to be equal.
© Nova Publishing Company, 2005