Friday, April 23, 2010

The Balance Sheet

Most people go to a doctor once a year to get a checkup—a snapshot of their physical well being at a particular time. Similarly, companies prepare balance sheets as a means of summarizing their financial positions at a given point in time.

A balance sheet utilizes double-entry accounting—a system that ensures that each transaction balances. This system relies on the following basic equation:

Assets = Liabilities + Owner's Equity.

Assets are the things a company invests in so that it can conduct business—examples include financial instruments, land, buildings, equipment, and commodities. In order to acquire necessary assets, a company often borrows money from others or makes promises to pay others. Monies owed to creditors are called liabilities. Owner's equity, also known as shareholders' equity, is what, if anything, is left over after total liabilities are deducted from total assets. Thus, a company that has $3 million in assets and $2 million in liabilities would have owner's equity of $1,000,000.





Owner's equity





By contrast, a company with $3 million in assets and $4 million in liabilities would have negative equity of $1 million—and serious problems as well.

Thus, the balance sheet "balances" your company's assets and liabilities: the promises and agreements made with customers are balanced against the promises and agreements made with vendors and stockholders. It provides a description of how much, and where, the company has invested (its assets)—broken down into how much of this money comes from creditors (liabilities) and how much comes from stockholders (equity). Moreover, the balance sheet gives you an idea of how efficiently your company is utilizing its assets and how well it is managing its liabilities.

Balance sheet data is most helpful when it's compared with information from a previous year.

The balance sheet begins by listing the assets that are most easily converted to cash: cash on hand, receivables, and inventory. These are called current assets.

Next, the balance sheet tallies other assets that have value but are tougher to convert to cash—for example, buildings and equipment. These are called plant assets, or, more commonly, fixed assets (because it's hard to move them).

Since most fixed assets, except land, depreciate over time, the company must also include accumulated depreciation in this part of the calculation. Gross property, plant, and equipment minus accumulated depreciation equals the current book value of property, plant, and equipment.

Here again, the balance sheet makes a distinction between short-term liabilities, also known as current liabilities, and long-term liabilities. Short-term liabilities typically have to be paid in a year or less; they include short-term notes, salaries, income taxes and accounts payable.

Subtracting current liabilities from current assets gives you the company's working capital. Working capital gives you an idea of how much money the company has tied up in operating activities. Just how much is adequate for the company depends on the industry and the company's plans. For 1998, Amalgamated had $868,000 in working capital.

Long-term liabilities are typically bonds and mortgages.

Total assets must equal total liabilities plus owners' equity. Thus, subtracting total liabilities from total assets, the balance sheet arrives at a figure for the owners' equity. Owner's equity comprises retained earnings (net profits that accumulate in a company after any dividends are paid) and contributed capital (capital received in exchange for stock).

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