Understanding the Balance Sheet

A balance sheet is a formal statement showing the financial position of an entity as of a particular date. The balance sheet is the only financial statement that reports as of a particular date compare to income statement, statement of changes in equity, and cash flows which all reports for a particular period of time. The balance sheet presents the three elements of financial position, namely assets, liabilities and equity.

Assets are defined as resources controlled by the entity as a result of past transactions and events and from which future economic benefits are expected to flow to the company. In layman’s language these are the properties owned by the entity.

Liabilities are defined as present obligations of an entity arising from past transactions or events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. In short these are the obligations that must be paid by the entity.

Equity is the residual interest in the assets of the entity after deducting all of its liabilities. It simply means net assets.

Financial reports users like investors, creditors and owners analyze the balance sheet to evaluate such factors as liquidity, solvency, financial structure and capacity for adaptation.

Liquidity is the ability of the entity to meet currently maturing obligations. Solvency is the availability of cash over the longer term to meet maturing obligations. Liquidity and solvency are the two factors that a creditor may evaluate upon the entity.

Financial structure is the source of financing for the assets of the entity. It shows how much is borrowed capital (capital obtained from creditors) and how much is equity capital (capital contributed by owners).

Capacity for adaptation is the financial flexibility of the entity to use its available cash for unexpected requirements and investment opportunities. This is also known as financial flexibility. It maybe accomplished by raising cash at short notice through borrowing or issuance of securities or by raising cash through disposal of assets without disrupting normal operations.

A company’s balance sheet has three parts: assets, liabilities and ownership equity (partners’ equity for partnership and stockholders’ equity for corporations). The main categories of assets are usually listed first and are followed by the liabilities. The difference between the assets and the liabilities is known as equity or the net assets or the net worth of the company; according to the accounting equation, net worth must equal assets minus liabilities.

Another way to look at the same equation is that assets equal liabilities plus net worth. This is how a balance sheet is presented, with assets in one section and liabilities and net worth in the other section. The sum of these two sections must be equal; they must be “balanced.”

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