# The Balance Sheet & The Fundamental Principle

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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

Assets

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.

Liabilities

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.

Balance Sheet

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.

Below is an example of a personal balance sheet:
We add up all your assets, which total to £113,500 in this case. These are your gross assets, which we usually just call assets.

We then deduct all your liabilities from these assets.

Her liabilities total £62,500 so when we deduct this amount from gross assets, we are left with £51,000. These are your net 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.

* NOTE: The brackets are common notation in the accounting world to indicate negative numbers.
Net 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.

Personal Balance Sheet Equation

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

[Optional] Difference Between Assets and Liabilities
http://keydifferences.com/difference-between-assets-and-liabilities.html
A company can have all sorts of assets and 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.

Example of a Company Balance Sheet
Just as we did for Sarah’s personal balance sheet, we can add up all the assets of Wingate Foods and deduct the liabilities to get the company’s net assets: £8,808k – £5,961k = £2,847k
Let’s now look at the section labeled shareholders’ equity.

This is simply another way of saying ‘net worth’, as we saw in the personal balance sheet.
1) Capital Invested

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.

2) Retained Profit (also known as Retained Earnings) is what the company has earned or saved. A company sells products or services for which the customers pay. For this, the company has to pay various expenses – to buy materials, pay staff etc.

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.

Company’s Balance Sheet Equation

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.

[Optional] Balance Sheet
Fundamental principle of accounting
As we have just seen, all the company’s assets are effectively owed to someone. Whether it is employees, suppliers, banks or shareholders, someone has a claim over each and every one of the assets.

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.

Balance Sheet Chart

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.
balance sheet chart consists of two bars, each of which contains a number of boxes. These can be interpreted in the following way:

• 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.

• The claims bar (right-hand bar) shows all the claims over the assets of the company. At the top we show the liabilities to third parties, which the company must pay at some point. At the bottom we show the claims of the shareholders (the shareholders’ equity) that the shareholders would get if all the assets were sold off. The height of this bar is thus the sum of the liabilities and the shareholders’ equity.
* NOTE: Keep in mind that the two bars are always the same height. This must be true by definition of our balance sheet equation.