Financial Statement Basics: The Balance Sheet

Choosing investments takes a lot of research into a company’s situation, past, present, and future. Periodically, companies make available certain financial statements that convey the firm’s financial position at a certain point in time in the past. The information contained in these statements gives clues to the company’s profitability and ability to compete with other firm’s in the same industry. Luckily, these statements follow certain rules and regulations that allow an investor to understand the corporation at a glance.

The Balance Sheet of a corporation is made up of three main parts. These parts have a relationship with one another which is known as the balance sheet identity. This identity is expressed with the equation:

Assets = Liabilities + Owners’ Equity

However, this identity is often confusing to the beginning investor. With a little math, the balance sheet identity can be rewritten as:

Owners’ Equity = Assets – Liabilities

This rewritten equation makes more sense because it is intuitive that the equity of the owners is made up of what the company is worth (assets) minus what the company owes (liabilities).

Assets are typically broken down into two types. The first type, current assets, is the firm’s assets that are most liquid. An asset is liquid if it can quickly be turned into cash with little loss of value. Cash is considered the most liquid asset and is sometimes synonymous with liquidity. Other liquid assets include accounts receivable, inventory, and those assets that are considered cash equivalents such as shares of stock in another company. An asset is generally considered current if it is expected to be turned into cash within one year from acquisition.

The second type, fixed assets, is the firm’s assets that are least liquid. In the market, they can not be quickly turned into cash without a significant loss of value. Such assets include property, plant, equipment and even intangible assets such as patents and trademarks. An asset is generally considered fixed if it is expected, at the time of acquisition, that it will not be turned into cash within one year. In fact, many fixed assets, such as buildings and land, are expected to stay on the company’s books for the life of the company.

Just like assets, liabilities are broken down into two types. The first type, current liabilities, is the firm’s liabilities that are expected to mature within one year. However, unlike assets, the maturity of a liability represents an outflow of cash rather than an inflow. Current liabilities include accounts payable, notes payable, and accrued expenses which are liabilities for which a good or service has been received but not yet paid for.

The second type, long-term liability, is the firm’s liabilities that have a maturity of more than one year. They include long-term bonds and even deferred taxes. Long-term liabilities often represent a major source of capital and funding for normal operations of a corporation.

Owner’s Equity (sometimes called stockholders’ equity) is the total value of the company’s stockholders and represents the second major source of capital for operations. This part of the balance sheet is comprised of the value of preferred stock, common stock, and retained earnings from operations. It is reasonable to think of owners’ equity as a plug number to make the balance sheet identity hold true. Owners’ equity is whatever is left over after the value of liabilities has been subtracted from the value of assets.