The Balance Sheet & The Fundamental Principle
In this lesson, you’re expected to learn:
– the difference between assets and liabilities
– what a personal and company balance sheet looks like
– the fundamental principle of accounting
An asset can be one of two things:
1) Something you own; for example, money, land, goods, shares in other companies etc.
2) Something you are owed by someone else, i.e. something which is technically yours but is currently in someone else’s possession. Most of the time it is money that you are owed but it could be anything.
A liability is anything you owe to someone else and expect to have to hand over in due course. Liabilities are also typically in the form of money.
A balance sheet is a table, listing all of someone’s assets and liabilities, along with the value of each of those assets and liabilities.
We then deduct all your liabilities from these assets.
Your net assets are what you would have left if you sold all your assets and paid off your liabilities. In other words, your net assets are what you are worth.
So how did Sarah come to be worth £51,000? There are two ways:
1) Inheritance: she could’ve been given some of her assets. This is what you start out with without having to earn it. In this case, she inherited £30,000.
2) Another way is by saving. This includes any assets that you can sell and turn into cash such as your house, jewelry etc. In other words, your savings refers to all your earnings that you haven’t spent yet.
Thus, what you have been given plus what you have saved totals to what you are worth today i.e. it must equal your net assets.
This is known as the balance sheet equation, as shown below:
Net Worth = Assets (gross) – Liabilities
1) Fixed assets: any assets that a company uses on a long-term basis (as opposed to assets that are bought and sold on to customers); e.g. buildings, machinery, computers.
2) Current assets: assets you expect to sell or turn into cash within one accounting year; e.g. stocks, cash in hand, amount owed to you by customers.
3) Current liabilities: like current assets, current liabilities are immediate liabilities of the firm that are to be paid within the next year; e.g. amounts owed to suppliers, short-term loans etc.
4) Long-term liabilities: liabilities you expect to pay but not within the next year; e.g. loans from banks.
This is simply another way of saying ‘net worth’, as we saw in the personal balance sheet.
This is the amount of money put into the company by the shareholders (i.e. owners). In other words, it is what the company starts with. It is the equivalence of ‘inheritance’ on your personal balance sheet.
However, this includes money invested by the shareholders at any time, just as you might get an inheritance at any point in your life. So it is basically money that the company has not had to earn.
As you’re aware, the goal of any company is to earn more from its customers than the expenses and thus make a profit. The company then pays out some of these profits to the taxman and the shareholders. What is left over is know as retained profit.
This is equivalent to the savings on your personal balance sheet. This retained profit is rarely solely in the form of money; usually it is made up of all sorts of different assets.
Thus, a company’s balance sheet equation is given by the following:
Shareholders’ Equity = Assets – Liabilities
Keeping this in mind, a company’s balance sheet equation can be rearranged and interpreted slightly differently.
Assets = Shareholders’ Equity + Liabilities
Assets must add up exactly to the liabilities plus the shareholders’ equity.
Thus, we can say that the assets of a company must always equal the claims over those assets.
=> Assets = Claims
This equation is the fundamental principle of accounting.
One of the benefits of looking at a balance sheet in this way is that we can display it in the form of a chart, which makes it a lot easier to see what’s going on.
• The height of each box is the value of the relevant asset or liability.
• The assets bar (left-hand bar) has all the assets of the company stacked on top of one another. The height of the bar thus shows the total (gross) value of all the assets of a company.