Balance Sheet Secrets REVEALED
with a Fun Demo
In this post, we’re going to cover the basics of the balance sheet. It’s also called the statement of financial position.
This is where many people get confused.
I’m going to be honest with you; it confused me for many years.
I’m going to explain it with a fun demo.
A Bit of Theory
(Don’t worry; fun bit is coming)
Before we get to the fun part, let’s just cover the theory first.
The Balance Sheet is one of the three main financial statements.
The other two are: Income Statement and Cash Flow Statement.
It’s critical to know how to read a balance sheet. If you want to understand the financial health of a business, that’s the place to start.
The Balance Sheet
The balance sheet looks like this.
Its purpose is to provide an idea about the company’s financial position at a certain point in time. It doesn’t show the flows into and out of the accounts during that period. That’s important to remember.
A balance sheet always only shows you information at a point in time; usually the end of the financial year, or for listed companies, it’s also the end of a quarter or half year. In the case of Microsoft in our example, it’s as of June 30th, 2018.
It shows you which assets the company owns, the liabilities it owes to others, and the equity that belongs to the owners.
In the first Accounting Basics video in the series, we showed the balance sheet at a T-account.
Now, Microsoft’s balance sheet isn’t structured like a T-account but in a list type of form. It could also be shown like a T, and you can see that both sides are in balance.
In this form view, it’s just easier to read.
Now that we cleared that up, let’s use a very simple example to see how these components work together.
Assets, Liabilities, and Equity
(How they work together)
In this example, we will demonstrate how assets, liabilities, and equity work together using orange juice and three glasses.
Let’s say we create a new company.
What do we need for that? Cash, right? Where do we get it from? Well, one way is that as the owners of the company, we’re going to put in our own private money into this company.
That’s called the equity.
We’re going to show this with a glass of water.
I marked the current level of equity with a green line here, but here’s the thing.
For most startups, its own equity is not enough. We need additional funds and we’re going to get a bank loan.
In our example, this glass of orange juice represents our bank loan.
I marked the current level with a red line.
Now currently, we only have balances on the credit side of the balance sheet. The balance sheet doesn’t balance, so what’s missing?
Credits represent the source, meaning where the money’s coming from. We are missing the debits.
Debits represent a destination, meaning where does the money go to? Or, what is it spent on? In our case, we didn’t spend it on anything yet.
All the money went to the cash account.
The cash account consists of the money we got from the owners and from the bank.
So, by just looking at the cash account, we can’t distinguish what came from where.
So, how much is our own funds and how much is externally financed? It’s just cash, orange juice with water.
What does the company do with its cash? It’s probably going to invest. Maybe it’s going to buy machinery.
Now, how does that affect the balance sheet? We take money out from the cash account and we put it into equipment.
The total amount of assets doesn’t change by that. We have less money in the bank but in exchange, we have the value of the equipment.
Now, if you start using the machine, it’s going to lose its value because we’re using it.
In accounting, this is reflected by depreciation.
Also, the company incurs expenses like personnel costs for its employees, because we have to pay salaries and wages, and these are taken out of the cash account.
In both cases, the financial value of the company decreases.
At the same time, our customers are happy and they pay for the products and services they got from us.
So we get money from them in our cash account.
Now, we want to know if in total we increased the financial value of the company since we started.
What do we need to do? We need to add up the value of the assets available at this point.
So which assets do we have? We have the current value of the machinery, which is what we initially paid for, minus the depreciation, so which is the decrease in value because of wear and tear, plus what we currently have in the bank.
That’s the total assets of the company.
Now, from this total, we need to deduct the debt of the company.
We can see this with the red marker on the glass.
Now, if the value of the remaining assets is higher than the original equity the owners paid in, the company made a profit and increased its financial value.
Let’s check. If it’s less, we made a loss. Now in our case, it’s higher than the green line, so we made a profit and increased the value of the company.
The important part of this exercise is that the glass with the equity was always empty.
That’s because equity on its own doesn’t really exist. What exists are the assets of the company and its debt. Equity is just a calculation of total assets minus debt.
It exists only on paper. The more assets a company has and the smaller its debt, the bigger equity will be.
It all comes back to the main accounting equation: assets equal liabilities plus equity.
If we rearrange this, equity equals assets minus liabilities.
The higher value for assets and lower value for liabilities, equals higher equity.
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