This article is number 2 of 3 and is related to the structure of the Balance Sheet which forms part of the Financial Statements
In our previous reference article I went through the structure of the Income Statement. If you haven’t read that yet you can find it here.
There are three key components that make up the Balance Sheet and yet, over time, they tell you so much about where a company has been, and also, where it is likely to go, based on its current trajectory. But I’m getting ahead of myself, we’ll get to that.
So here they are:
- Total Assets
- Total Liabilities
And the following will always be true:
Total Assets (A) = Total Liabilities(L) + Equity (E)
A = L + E (we’ll come back to this)
Assets are the things that a business owns that ultimately make you money. Your job, as a business owner, is to create and acquire assets that you can turn in to revenue.
So what are examples of assets? Well any number of things but could include:
- Plant & Equipment
- Intellectual Property
- Accounts Receivable (money owed to you by your customers)
On a Balance Sheet the Total Assets are split into two areas:
- Current Assets
- Non-Current Assets
These are assets that could be turned in to cash in less than 12 months. They are of a more transient, or liquid, nature. Key examples are:
- Accounts Receivable
These are assets that have a longer lifespan and would take more than 12 months to monetise. Key examples are:
- Plant & Equipment
It’s true you could sell these items but whilst you own them they won’t magically turn in to cash whilst you own them. They may generate you cash but this is captured as a separate, current asset.
Liabilities are items that constitute an obligation of the company to repay someone something in the future.
So what are examples of liabilities?
- Business Loans
- Business Overdrafts
- Employee Entitlements (Unpaid Wages, Superannuation, Long Service Leave etc)
- Accounts Payable (money owed by you to your suppliers)
Like assets, on a Balance Sheet the Total Liabilities are split into two areas:
- Current Liabilities
- Non-Current Liabilities
These are liabilities where your obligation to pay is within 12 months. Key items included are:
- Business Loan Principal (component less than 12 months)
- Employee Entitlements
- Accounts Payable
Non Current Liabilities
These are liabilities where your obligation to pay is beyond 12 months. Key items included are:
- Business Loan Principal (component beyond 12 months)
You will see variations on this but the equity component of the Balance Sheet will generally include two key items:
- Shareholder Contributions
- Retained Earnings
Shareholder Contributions is money put in by shareholders in exchange for shares in the company (equity). Retained Earnings are the profits from previous periods that have NOT been distributed to shareholders by dividend but retained by the company to use at a later date.
Remember the formula I provided earlier? A = L + E. Well if we rearrange that we can also express it as E = A – L. Essentially, equity is the value that is owned by the shareholders (Total Assets – Total Liabilities). If the business was wound up it represents what the shareholders would be left with. If this is more than they originally contributed, they are in front (value was created). If it is less than they originally contributed, they are behind (value was destroyed).
So that’s the balance sheet. Doesn’t seem to complicated right? Ostensibly it isn’t but the real power comes when we start using the different numbers it contains to calculate ratios and percentages. When compared over time, and against other similar organisations, it will tell you huge amounts. But that will come later!