The actual snapshot of the financial health of a company is usually determined by a document referred to as the Balance Sheet.
Many business owners think only of profit only when evaluating where they stand financially. The report used to determine this is commonly referred to as an ‘Income Statement’ or a P&L (Profit or Loss) Statement. While this is certainly indispensable, it only represents a portion of the financial picture.
There are three main areas of a balance sheet, and they consist of the following:
- Assets – These are things that the business owns that are regarded as items of value and are available to meet debt obligations or commitments. Typical assets include but are not limited to cash, accounts receivable, real property and inventory.
- Liabilities – These are items that represent a company’s legal debts or financial obligations. These can include accounts payable, notes payable, credit cards and taxes payable.
- Equity – This is sometimes referred to as Owner’s Equity or Shareholder’s Equity. This normally consists of company stock and undistributed earnings, (also referred to as retained earnings).
These three sections appear on every balance sheet which in its simplest form consists of the following equation.
Assets = Liabilities + Equity
This is also commonly referred to as the ‘Accounting Equation’. (Just type that in to a search engine and see how many results you get.)
Using simple algebra there are two other ways to represent the accounting equation.
Equity = Assets – Liabilities
Liabilities = Assets – Equity
So, let’s say your company has $100,000 in the bank, and you owe $35,000 on your company Rolls Royce. Your equity is $65,000. So doing a quick calculation, you can put these values into the three formulas above, and the results will always be correct. Do you notice how these formulas balance when you substitute the real numbers? That’s why it’s called a ‘Balance Sheet’.
You can also use this technique to calculate your personal ‘Net Worth’. Add up everything you own, subtract everything you owe and you will have a number that shows your Net Worth or personal equity.
In a future article, we will look further into how accounting works and why it’s important in running a business.