(Source: http://www.federalreserve.gov/newsevents/speech/bernanke20091008a.htm retrieved 4/7/2014)

 

 

How the balance sheet works

The balance sheet is divided into two parts that, based on the following equation, must equal each other, i.e., “balance”. The formula behind the balance sheets is

Assets = Liabilities + Shareholders' Equity

 

This means that assets, or the means used to operate the company, are balanced by a company's financial obligations, along with the equity investment brought into the company and its retained earnings.

Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity (referred to as shareholders' equity in a publicly traded company) is the net worth of the company (Assets minus Liabilities): it is the amount of money invested initially into the company plus any retained earnings minus any losses; it represents a source of funding for the company.

It is important to note that a balance sheet is a snapshot of the company's financial position at a single point in the past, the end of the company’s fiscal year.  It is always an indication of what the company’s position was, not what it is at the present moment.

 

Types of assets

a.  Current assets

Current assets have a lifespan of no more than one year, meaning they can be converted easily into cash. Assets in this category include (1) cash, (2) cash equivalents, (3) accounts receivable, (4) inventory, and (5) prepaid expenses. Cash also includes bank demand accounts (accounts from which the business can withdraw its money at any time without restriction) and checks, as well as just currency in hand. Cash equivalents are very safe investments that can be quickly converted into cash; government treasury bonds are one such example. Accounts receivable are the short-term obligations (debts) owed to the company by its customers. When a business sells a product or service to a customer on credit, the amount owed is held in the accounts receivable account until the debt is paid by the customer.

Inventory is the monetary value of all finished goods in stock as well as all raw materials and work-in-progress goods in the business’s possession. The makeup of the inventory account will differ depending on the type of business. For example, a manufacturing firm will carry a large amount of raw materials, while a retail store carries none. The makeup of a retailer's inventory typically consists of goods purchased from manufacturers and wholesalers.
Lastly, prepaid expenses are any expense the business pays for in advance, such as rent, insurance, office supplies, postage, travel expense, or advances to employees. They also list as current assets, as long as the company envisions receiving the benefit of the prepaid items within 12 months of the balance sheet date.

b.    Non-current assets

Non-current assets are assets that are not turned into cash easily, are not expected to be turned into cash within a year and/or have a lifespan of more than a year. They can include tangible assets such as property (land), plant (factory), buildings, and equipment (machinery, tools, and computers). Non-current assets also can be intangible assets, such as goodwill and intellectual property like patents, copyright, and trademarks. While these assets are not tangible, they are often the resources that can make or break a company – for example, the value of a brand name like Levis or Starbucks can be worth a fortune.

 

Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.

Types of liabilities

On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to other entities. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of more than one year from the date of the balance sheet. Non-debt long term liabilities may include future pension payments, rents on long term leases, and other contractual commitments. Current liabilities are the company's obligations that will come due, or must be paid, within one year. This includes both shorter-term borrowings, such as accounts payables, along with the current portion of longer-term borrowing, such as the latest interest payment on a 10-year loan.

Shareholders' equity

Total shareholders' equity is the sum of (1) the total amount of money initially invested in the business, plus (2) all accumulated retained earnings, minus (3) all accumulated losses in previous years. Retained earnings are after-tax profits not paid out as dividends, but reinvested in the company at the close of each fiscal year.  They are credited to the stockholders’ equity account. Likewise, in years where the company loses money (does not make a profit), the amount of the loss is debited from the shareholders’ equity account. The shareholders’ equity account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.

---

10.2.2 Balance sheets and income statements