Balancing Out the Balance Sheet Equation
In this section, we’ll focus on walking through the balance sheet and cover the key balance sheet equation. We’ll break out each term and explain in simple language what each of these mean (I’ve read far too many business textbooks and my goal is for this to not read like one). So let’s jump right in!
High level, a balance sheet is a snapshot in time of what a business has (anything of value) and what it owes others. If the value of what a business has is more than what it owes, the business is worth something to its owners. On a balance sheet, we’ll be using three terms a lot which are “assets”, “liabilities” and “equity”. Let’s define each of these below with some examples of each:
Assets: The value of what a company has. Assets can include cash, equipment, property, inventory and a number of other things.
Liabilities: The value of what a company owes others. Liabilities can include money it owes to banks, employees (like their salary), suppliers and so on.
Equity: The value of the company to its owners. It is also referred to as “shareholders’ equity” since the owners are the shareholders of the company. This is the difference between the amount of assets and liabilities that the company has.
The Core Balance Sheet Equation
Assets – Liabilities = Shareholders’ Equity
Let’s use an example to walk through this balance sheet equation. Say that you sell bikes over the internet and have $1000 of bikes on hand today. Let’s also say that you still owe one of your suppliers $250 that you’ll have to pay off within the next month. In this case, the total amount of assets you have is $1000 which is the value of the bikes you currently own. The liabilities that you have are $250 since you’ll have to pay that amount to your supplier. So how much are the bikes worth to you? We can take the value of the assets ($1000) and subtract off the liabilities ($250) using the balance sheet equation to get the total owner’s equity, which is $750.
Example of a Company’s Balance Sheet
In the next few sections, we’ll be digging more into the key terms and how they fit in the balance sheet. As we go through, it’s easy to get lost in the details but always keep in mind the key thing that we’re trying to do: calculate how much a company has, how much it owes and how much it is worth to its owners. Each of the sections below are just a way of getting to that point. In a standard balance sheet, all of a company’s assets are listed on the left hand side. On the right hand side, the company’s liabilities and shareholder’s equity are listed. Since we want the left and the right side to balance, we’ll change up the key balance sheet equation to:
Assets = Liabilities + Shareholders’ Equity
Shown above is an example of a standard balance sheet. In the next section, we’ll start going through the left side of the balance sheet starting with current assets. Make sure to sign up for our mailing list for the most recent updates on new more financial content from New Business Playbook!
Key Takeaway: The key goal of a balance sheet is to show what a company has, what it owes and how much it is worth to its owners. The balance sheet equation is used to make both sides balance which means assets need to equal liabilities plus shareholders’ equity.