Examining a Balance Sheet Model for a Business
The balance sheet is one of the primary financial statements prepared for businesses. Examining a balance sheet model for a fictional company can help you to understand the content and structure of a typical balance sheet.
Components of a balance sheet
This illustration shows the basic information components of a typical balance sheet. One reason the balance sheet is called by this name is that its two sides balance. In the example, the $5.2 million total of assets equals the $5.2 million total of liabilities and owners’ equity.
Notice that the balance sheet in the illustration is presented in a top and bottom format, instead of a left and right side format. Either the vertical or horizontal mode of display is acceptable. You see both the portrait and the landscape layouts in financial reports.
Generally, five or more assets are reported in a typical balance sheet, starting with cash, and then receivables, and then cost of products held for sale, and so on. Generally five or more liabilities are disclosed, starting with trade credit liabilities, unpaid expenses, and then interest-bearing debts of the business. Two or more owners’ equity accounts are generally reported.
You’ll find 12 or more lines of information in most balance sheets. Each of these information packets is called an account — so, a balance sheet is comprised of asset accounts, liability accounts, and owners’ equity accounts.
Looking at the assets
Most businesses need a variety of assets. You have cash, which every business needs, of course. Businesses that sell products carry an inventory of products awaiting sale to customers. Businesses need long-term resources that are generally called property, plant, and equipment; this group includes buildings, vehicles, tools, machines, and other resources needed in their operations. All these, and more, go under the collective name “assets.”
The illustration includes just four basic assets. These are the assets that a business selling products on credit would have. It’s possible that such a business could lease its long-term operating assets instead of owning them, in which case the business would report no such assets. In this example, the business owns these so-called fixed assets. They are fixed because they are held for use in the operations of the business and are not for sale, and their usefulness lasts several years or longer.
So, where does a business get the money to buy its assets? Most businesses borrow money on the basis of interest-bearing notes or other credit instruments for part of the total capital they need for their assets. Also, businesses buy many things on credit and at the balance sheet date owe money to their suppliers, which will be paid in the future.
Could a business’s total liabilities be greater than its total assets? Well, not likely — unless the business has been losing money hand over fist. In most cases, a business has more total assets than total liabilities. Why? For two reasons:
Its owners have invested money in the business, which isn’t a liability of the business.
The business has earned profit over the years, and some (or all) of the profit has been retained in the business. Making profit increases assets; if not all the profit is distributed to owners, the company’s assets rise by the amount of profit retained.
Looking at equity
In the example shown in the illustration, owners’ equity is $2.47 million. Sometimes this amount is referred to as net worth, because it equals total assets minus total liabilities. However, net worth isn’t a good term because it implies that the business is worth the amount recorded in its owners’ equity accounts.
The market value of a business, when it needs to be known, depends on many factors. The amount of owners’ equity reported in a balance sheet, which is called its book value, isn’t irrelevant in setting a market value on the business — but it is usually not the dominant factor. The amount of owners’ equity in a balance sheet is based on the history of capital invested in the business by its owners and the history of its profit performance and distributions from profit.
When do you create a balance sheet?
A balance sheet could be whipped up anytime you want, say at the end of every day. In fact, some businesses (such as banks and other financial institutions) need daily balance sheets. Typically, preparing a balance sheet at the end of each month is adequate for general management purposes.
In external financial reports (those released outside the business to its lenders and investors), a balance sheet is required at the close of business on the last day of the income statement period. If its annual or quarterly income statement ends, say, September 30; then the business reports its balance sheet at the close of business on September 30.