Axiom CPA, P.A. - Axiom CPA Blog

All first year accounting students are taught a simple formula that is the basis for understanding the balance sheet: assets = liabilities + equity. We're going to break down these three elements in the most basic terms so you can understand exactly what a balance sheet is trying to communicate.

First, assets. This is what you own. Sometimes you may own it with the bank, but never-the-less you own it. Things like cash in the bank, accounts receivable, deposits with utility companies, equipment, cars, real estate, etc. Notice there's a particular order to the above list. The assets listed first are readily convertible to cash while those at the end are less so. This is also how assets are presented on the balance sheet. Those that are 'current' or easily converted to cash are listed first while those that are 'non-current' are listed toward the bottom.

Second, liabilities. These are what you owe. Accounts payable, credit card balances, the outstanding balances on lines of credit and mortgages are all examples. Again, the 'current' liabilities, those that must be paid soonest are listed first while 'long-term' liabilities such as mortgages come last.

Equity by definition is what's left over. If you do a little algebra on the above formula you can restate it as assets - liabilities = equity. Common forms of equity are capital contributed by the owners and retained earnings. This last area, retained earnings, is what ties the balance sheet and the income statement together. The very bottom number on the income statement, the net income number, flows through to the equity section of the balance sheet as retained earnings.

Now, the beauty of accounting is that this formula ALWAYS has to be in balance. So let's say I borrow $100,000 from the bank and deposit it into my business bank account. My assets go up by $100,000 because my bank account balance went up. My liabilities also go up because I now owe the bank $100,000. There is no change in equity.

As another example suppose I took $100,000 out of my personal savings and gave it to the business. Assets go up by the same $100,000 but I don't owe anyone anything. My contribution of capital is considered equity so it goes up $100,000.

Before we move on to the income statement and how it affects things lets consider a transaction that occurs completely in one category. Suppose, I sell a piece of equipment and get $5,000 cash for it. My assets increase $5,000 from the cash received but my assets also decrease by $5,000 because the equipment is no longer mine. So there's no change in total assets, no change in liabilities and no change in equity. A similar situation can occur when a loan is refinanced. You're just trading one liability for another.

As mentioned earlier, transactions on the income statement also come into play. When a customer pays you for goods or services it increases your profits, thereby increasing the retained earnings in the equity section of the balance sheet. Assets also go up because you receive cash as part of the transaction. If you offer your customers credit then it's not cash that goes up, it's your accounts receivable asset that goes up. Any transaction can be broken down this way.

I like to use an analogy when comparing the balance sheet and the income statement. Picture a runner on a track. The income statement is a reflection of how fast the runner can get around the track. But the balance sheet is like a report from the runner's doctor that tells you how healthy he is. It's possible that the runner can turn out an impressive time on the track, but drink a fifth of vodka and smoke a pack of cigarettes when no one is watching. If you can get the runner to do two laps, or three laps, of ten laps you'll probably be able to tell if he's not in the greatest shape. But if you only have time to watch one lap you may get misled. Or better yet, suppose you are trying to determine BEFORE the race starts just how many laps he's going to be able to complete. It would be nice to have the doctor's report to get some real predictive insight into how fit the runner really is.

The balance sheet provides just such a picture of a company's health. If you see a company with very few current assets (cash and receivables) but a lot of current liabilities such as accounts payable, credit card debt and short-term lines of credit you should know you've got a potential problem on your hands. If you see a company that has very little equity and a lot of assets you need to hone in on the liabilities and understand them because that's what is keeping the business running. If you look at two companies and one requires twice as many assets as another to produce the same amount of profit you might want to find out if those assets need to be replaced.

The balance sheet is the least understood financial statement, but it holds the promise of far greater understanding of your company and your ability to continue in the face of tough economic times. We've only scratched the surface. If you really want to get excited give us a call and we'll go through your balance sheet with you so you can start increasing the financial IQ of your business.