The purpose of the balance sheet is to report the way the resources to run the operations of the business were acquired. The Balance Sheet helps us to assess the risk of the business. By looking at it, you will be able to answer questions, such as: What is the leverage? Is the company liquid enough? Remember, leverage is the proportion between equity and debt, while liquidity is the capacity of the business to repay for its short-term obligations, to run the operations.
Why the balance sheet is important
It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations (accounting), enhances a person’s ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision- making by Alan Greenspan former FED Governor
Understanding the balance sheet is critical to be able to dissect any business. We’ll start from the ten commandments of the GAAP accounting system.
A quick introduction to the main GAAP principles
Although the fundamental accounting system hasn’t changed, the principle and rules applying today have been updated in the last century.
The generally accepted accounting principles are standards and procedures used by organizations to submit their financial statements. Today we have two main accepted frameworks, globally: GAAP and IFRS. Indeed, after the 1929 market crash, the American government felt the necessity to create a set of rules to discipline and to harmonize the accounting system, and avoid what had happened. In the decade after the 1929 market crash institutions such as the Securities and Exchange Commission were created.
In 1934, the SEC, assisted by the American Institute of Accountants (AIA), started to work on the GAAP. The AIA subsequently instituted an organism to specifically create these principles, The Committee on Accounting Procedure (CAP).
Finally, the first set of GAAP was created, and in 1973 and the CAP board was substituted by the Financial Accounting Standards Board (FASB). From this work came out ten basic principles, that are the foundation of the modern accounting system in the US:
- Economic entity assumption: If you have a business, even if you are a sole proprietor, the accountant will consider yourself separately from your business.
- Monetary Unit Assumption: The Business activity you undertake is considered in US Dollars.
- Time Period Assumption: a Business activity you undertake can be reported in separated time intervals, such as weeks, months, quarters or fiscal years.
- Cost Principle: If you buy an item in 1980 at $100, it will be reported on your balance sheet as worth $100 today, independently on inflation or appreciation of the asset.
- Full Disclosure Principle: You have to report all the relevant information of the business in the financial statements or the footnotes.
- Going Concern: The accountant assumes that your business will continue its operations in the foreseeable future.
- Matching Principle: If you incur an expense, it should be matched with the revenues, according to the accrual principle. If you decide to pay your employees a bonus related to 2015 but you pay it in 2016, you still will report it as 2015. You will report the expense when it was recognized and not when actual cash disbursed (accrual principle).
- Revenue Recognition Principle: if you sold a product in January 2015, but you will receive the money from the customer in April 2015, you will report the sale in January, since it was the period when the actual sale was realizable.
- Materiality Principle: when you report the financials, it will be allowed to round them, since if an amount is insignificant can be neglected by your accountant.
- Conservatism Principle: When in doubt between $80 or $100 loss, your accountant has to choose the most conservative alternative, report $100.
These principles are the “ten commandments” of the accountant. Keep them in mind. They will guide you throughout the book. Also, the accrual principle in practical terms states: “Revenues and expenses are recognized when occurred, independently from cash disbursement.”
This principle is crucial to building our primary financial statements, in particular, the Income Statement and Balance Sheet.
A quick glance at the main accounts of a financial statement
An account is an item on the financial statements that has certain characteristics. Usually, accountant group them in five main types. Each of those types has subtypes. For now, it is critical to understand each main type to have a better understanding of how financial statements work. The main accounts are:
- Assets: Resources owned by an organization. They will produce future benefits for the company. For example, you own a bakery that has to produce biscuits. For you to produce them, you have to buy a machine. The machine will be an asset to your organization.
- Liabilities: Obligations (Debt) contracted by an organization. Your bakery bought $100 of raw material from the supplier, and you will pay in 60 days. Until the payment will be made the $100 will show as a liability (future debt) on your balance sheet.
- Owner’s Equity: Amount of money or resources you endowed to your organization. The accounting definition is Owner’s Equity = Assets – Liabilities.
- Revenue or Income: The $ amount of sales occurred in a certain period. According to the accrual principle, income is recognized independently from cash receipt.
- Expenses: The $ amount of costs occurred in a certain period. According to the accrual principle, expenses are recognized independently from cash disbursement.
While assets, liabilities and equity will be shown on the balance sheet. Revenue and expenses will be shown on the income statement.
A snapshot of the primary financial statements
“Unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself” Warren Buffet
The primary financial statements are Balance Sheet, Income Statement and Cash Flow Statement. Each of these statements has a different purpose, and together they give us specific information in regard to: “Return, Risk and Cash.”
First, if you look at the income statement, there is no way you would make any assessment about the risk of the organization in that particular point in time or the cash produced in a certain period. Instead, the Income Statement (or Profit & Loss) will show you the return generated by the business.
Second, if you want to understand how an organization acquired the resources to operate the business, you have to look at the Balance Sheet. How does the balance sheet assess the risk of an organization? Simple: there are two ways a company can acquire resources, either through Equity or Debt.
As you can imagine, too much debt can be dangerous. What would occur if you run a business, and suddenly your creditors ask for the money you owe them? You would go bankrupt. Instead, when debt in proportion to the equity is dismal, this makes your organization creditworthy and safer.
Third, it is highly probable seeing an organization which makes profits but out of cash. The cash flow statement helps you to answer questions such as: How much cash did we make? Where this cash came from? An organization can find cash through three main activities: Operating, Investing and Financing.
What is the income statement?
The primary purpose of the income statement is to show the return of the business in a certain period: Quarterly, Biannually or Yearly. The income statement is built around the bottom line, the “net profit.” Do not be surprised to notice your eyes unexplainably falling on the net income. Accountants make it as visible as a fluorescent fish ready to mate. This distracts you by other metrics on the Income Statement that are as important as the Net Income.
What is the balance sheet?
The primary purpose of the Balance Sheet is to show the risk of the business in the particular moment you are looking at it. If you look the balance sheet on January 1st, it won’t be the same on January 2nd. Of course, this is true for the P&L and CFS (Cash Flow Statement) as well, but the balance sheet
is an instant snapshot of the business more than a collage of pictures taken in different moments, like the Income Statement.
What is the cash flow statement?
The primary purpose of the CFS is to show the cash generated by an organization in a certain period: Quarterly, Biannually or Yearly. It doesn’t matter how much profits a business is making, one way to know whether the business will survive in the next future is to look at the cash. Generating cash is not an easy task, and the organizations who can keep their profits stable and make enough cash to sustain their operations and invest for future growth are the ones who thrive.
All you need to know about the Balance Sheet
The purpose of the balance sheet is to report the way the resources to run the operations of the business were acquired. The Balance Sheet helps us to assess the risk of the business. By looking at it, you will be able to answer questions, such as: What is the leverage? Is the company liquid enough? Remember, leverage means the proportion between equity and debt, while liquidity is the capacity of the business to repay for its short-term obligations, to run the operations.
Imagine you have to open a restaurant. The overhead costs, plus the costs of running the business are $200,000. There are two ways for you to find the money needed to open the business, assuming you don’t have the resources to do it your own. Either you find a partner that would put personal money, or you ask for a loan. Therefore, Equity and Debt are the two ways to finance your business. This is how a typical balance sheet looks like:
To have a deep understanding of the balance sheet look this video, we put together for you:
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