3.7 The Balance Sheet and Net Worth

A snapshot, and the equation that balances it

A balance sheet sets what a business owns against what it owes and what its owners are left with, all as of one specific moment. Notice how the time frame has changed. An income statement covered a stretch of activity, a month or a quarter of it. This page covers an instant instead: a single date sits at the top, and each figure below is accurate on that date and free to move by the following morning. If the income statement is the movie, this is the photograph.

A = L + E

One equation organizes the page, known as the balance sheet equation and also as the fundamental accounting equation. The way to read it is as a statement about financing. Anything of value in the business's hands was paid for by somebody, either a lender who has to be repaid or an owner who keeps whatever survives. What the business has therefore always equals the claims standing against it. Both sides agree by definition, which is the reason behind the name printed at the top.

Assets, in liquidity order

Assets cover every item of value in the business's hands, and the sheet arranges them by liquidity, which measures how readily something turns into cash. Cash itself heads the list, having nothing to convert, and a commercial refrigerator ranks far below it, because unloading one needs weeks and a buyer who wants it.

Current assets come first: the highly liquid items that fund day-to-day operations. The group covers cash, short-term investments, accounts receivable, and inventory. A receivable is money owed to the business by customers, so an invoice issued on thirty-day terms sits here until the check clears. A business holding no short-term investments simply shows no line, because a sheet lists what exists rather than every category that could exist.

Long-term assets come next, made of fixed assets and long-term investments. Fixed assets are the physical property the business operates with, from a manufacturer's production plant down to a small shop's equipment, and they appear at book value rather than at purchase price because equipment loses value with use. Nineteen thousand dollars of equipment bought over three years can appear at a $12,000 book value for exactly that reason.

The third group is intangible assets: patents, brand names, and trademarks. They have no physical form and carry value because they represent potential revenue. A brand a founder built herself can pull customers through the door and still show no line, because only a purchased intangible arrives with a price to record.

Liabilities, ordered by due date

Liabilities are the debts and obligations the business owes, grouped by when payment comes due. Current liabilities are due within one year and cover accounts payable, short-term debt, current payments on long-term debt, and accrued expenses, which are costs already incurred but not yet paid, such as wages earned since the last payday.

A receivable and a payable describe a single arrangement from opposite chairs. The invoice a business issued is its receivable; the invoice it received is its payable. The current portion of a long-term loan deserves particular attention, because one loan appears twice on the same page. If a $6,000 loan balance retires $250 of principal in each of the next twelve monthly payments, $3,000 of it is current and the remainder is long term.

Long-term liabilities are obligations to pay beyond one year, and at larger scale the group holds mortgages, long-term bank loans, and bonds. Sorting debt by due date is what lets a reader judge whether the coming year is survivable separately from whether the total borrowing is reasonable.

Owners' equity, and what it decomposes into

Owners' equity is the net worth of the business to its owners, and the equation produces it as the difference between assets and liabilities. Assets of $24,500 against liabilities of $7,500 leave $17,000 of equity, the part of everything the business holds that no lender can claim.

That figure decomposes into two pieces: what the owner put in, and what the business kept. A $6,000 founding contribution together with $11,000 of retained earnings, meaning profits accumulated and never distributed, produces that $17,000. At a corporation the same logic appears under different labels, stock alongside retained earnings. Given two of the three totals on an exam, solve for the missing one. Given all three, verify that the sides agree, since a sheet out of balance is a sheet containing a mistake.

A balance sheet also typically prints a second column beside the first, showing the same snapshot from a previous year for comparison. One column reports condition and two columns report direction. A prior-year column showing $19,400 of assets, $10,400 of liabilities, and $9,000 of equity turns this year's page into a story: the loan balance fell by $3,000 and equity climbed $8,000, roughly the year's profit that stayed inside the business after owner draws.

Reading the sheet like a lender

Internal stakeholders read this page first, meaning the owners and managers who check the cash line before committing to new equipment. External stakeholders read it next, meaning lenders and investors evaluating financial condition as of a single date. A loan application puts this exact page in a loan officer's hands, and the officer runs three checks.

1. Is net worth positive, meaning do assets exceed liabilities?
2. Is there sufficient working capital, meaning do current assets meet or exceed current liabilities so that day-to-day operations stay funded?
3. Is the debt level comparable to similar businesses?

Current assets of $12,500 against current liabilities of $4,500 mean the business could pay everything due this year almost three times over, and $6,000 of loan against $24,500 of assets is modest for a small operation. Those same three checks describe failure as well. A business that cannot reach enough current assets to keep operations funded may close its doors or file for bankruptcy, a legal proceeding in which assets are sold off, debts are cleared or rescheduled, and the business either shuts for good or reorganizes under a court's supervision.

The same equation, run on a household

Personal net worth adds everything a household owns, meaning savings and investments, property, and personal possessions, then subtracts everything it owes. A student with $220 in savings, $160 in checking, and about $360 of belongings holds $740 of assets, and a $60 remainder on a family advance is her only liability, so her net worth is $680. Beside a business at $24,500 equals $7,500 plus $17,000, it is the same equation with different zeros.

Net worth is typically calculated for an entire household, which may include more than one person, so a full version adds every member's assets and debts, a home and its mortgage included. A lender asks a household for this page for exactly the reason a bank asks a business. Before anyone signs a mortgage or a car loan, the application wants both sides of the equation on paper. Households and financial planners then put the identical figure to a further use, answering the money question with the longest horizon of all: is there enough set aside to stop working.

Essential knowledge covered on this page