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Balance Sheet Identity
The balance sheet of a firm is a snapshot of a company’s financial situation at one point in time and is made up of three parts: the company’s total assets, liabilities, and stockholders’ equity. The balance sheet is the source of information that allows calculations of the most common accounting ratios used in business such as liquidity ratios which measure a firm’s liquidity. For example, the current ratio is calculated by dividing the current assets by the current liabilities and the quick ratio (also called the acid test) is given by current assets minus inventory all divided by current liabilities. However, the balance sheet identity itself is the key to understanding the usefulness of each ratio.
The balance sheet identity is given as:
Total Assets = Liabilities + Stockholders’ Equity
At first glance, this relationship does not seem intuitive. How can the assets of a corporation equal the addition of stockholders’ equity and liabilities? A little algebra and the identity comes to light. Solving the equation for stockholders’ equity is the key. If we subtract liabilities from both sides we get:
Assets – Liabilities = Stockholder’s Equity
By transposing this equation, we get:
Stockholder’s Equity = Assets – Liabilities
The equation now makes much more intuitive sense. Stockholders’ Equity is a residual representation formed by subtracting what the company owes (liabilities) from what it is worth (assets). This equation reveals that the addition of assets (such as cash, accounts receivable, inventory, etc.) increases stockholders’ equity and the addition of liabilities (such as accounts payable, notes payable, and long-term bonds) decrease stockholders’ equity.
The left hand side of the balance sheet represents the investment decisions of the organization and the right hand side represents the financing decisions. Liabilities are considered a financing option because it is a method of bringing money into the organization to finance its operations. Stockholders’ equity is whatever is left over if the assets of an organization outweigh its liabilities. When current liabilities (short-term debt) outweigh current assets (liquid assets), a firm is in default of its obligations and usually files for bankruptcy unless an alternative method of paying off its creditors can be found.