Balance sheet is another important financial statement that gives a snapshot of a company’s financial position and reports on its assets, liabilities and equities. These three are related by the following formula: Assets = Liabilities + Equity. This formula should be quite intuitive. Anything you own (assets) needs to be financed by money that you either borrowed (liabilities) or that you received from investors (equity).
To better understand, let’s further break down each of the three types.
Assets refer to any resource that a company owns and has an economic value attached to it. Assets, for a company, are those resources that the company utilizes to fulfill its operative needs and generate cash flows in the future. Examples of such assets can be – cash, investments, inventory (raw materials/ component parts), equipment, furniture, machinery, etc. Recorded on the left side of the balance sheet, they are divided into current and fixed assets. Fixed and current assets are differentiated based on liquidity. The term liquidity means how easily an asset can be converted into cash.
Current assets are those assets that can be cashed out within one year. It means they are short-term economic resources that are expected to convert into cash quickly. These include cash, cash equivalent, accounts receivable (balance to be paid by other institutions/bodies to the company), inventory, etc.
Fixed assets or non-current assets are long-term, valuable resources that have a useful life of more than a year. They cannot be converted to cash quickly and are mentioned at the price the company purchased them. Examples include land, building, heavy equipment, and machinery. However, a section of depreciation is added to compensate for their time and usage. Depreciation is the revaluation of fixed assets for their useful life and is calculated by subtracting resale value from purchase value. The difference is depreciated evenly over the expected years of life.
Liabilities, on the other hand, are something that the company owes to other institutions and is recorded on the right side of the balance sheet. They show how a company finances its assets and are settled through different means such as money, goods, and services. Common examples of liabilities are loans, mortgages, and accrued expenses (accumulated over time).
Like assets, liabilities are also of two kinds: current liabilities and non-current/long-term liabilities.
Current liabilities are debts that the company needs to pay within one year, ideally with cash. Common examples are money owed to vendors, utilities, employees’ wages, and dividend payments.
Non-current liabilities, on the other hand, are debts payable in 12 months or more. For example, if a company raises money through bonds with a maturity date of more than a year, it must pay back its investors in the long term. Hence, these bonds can come under non-current liabilities. Other common examples can be a large loan taken from a bank, warranties, and pension obligations.
Lastly, the equity section in the balance sheet refers to the company’s ownership and how much money it has put into the business. If the company is small and private, it might not have many shareholders and is owned by 2-3 people. The money that they have invested, without taking loans, is equity.
For publicly listed companies, money received from investors will come under equity because investors are now shareholders and have put some money in it to buy their shares.
An increase (+) in an asset account is a debit and an increase (+) to a liability account is credit; conversely, a decrease (-) to an asset account is a credit and a decrease (-) to a liability account is a debit. They are recorded in a company’s balance sheet.