—----------------------------------------------

At its core, the Balance Sheet is a snapshot of a company's financial health at a specific point in time. By understanding its components, we gain valuable insights into the company's capital structure, its ability to meet financial obligations, and its potential for future growth.

For those approaching the Balance Sheet from non-business backgrounds, the initial apprehension is understandable so this post aims to employ relatable analogies and simplify complex terms of the Balance Sheet.

—-----------------------------------------------

In the previous post, we unpacked the Balance Sheet’s essence, understanding its definition and key components - assets, what the company owns; liabilities, what it owes; and equity, its net worth. 

As mentioned, the Balance Sheet boils down to the golden rule, "Assets" must always equal "Liabilities + Equity" (Assets = Liabilities + Equity). Imagine it as a financial seesaw—whatever is on one side must be balanced by the other. This equilibrium ensures that a company's resources (Assets) are always accounted for, either through debts owed (Liabilities) or the ownership interest (Equity).

In the upcoming section, we will look at the structural intricacies of a Balance Sheet, demystifying the components based on the golden rule and equation. 

Structure of the Balance Sheet explained

Disclaimer: Balance Sheet varies between organizations and industries, however there are buckets that are almost always included in common Balance Sheets that non-business needs to understand. So this post will focus on these items: Assets (current & non-current), Liabilities (current & non-current), Equity.

The report form is the classic reports of the Balance Sheet that companies share.  It is simple with just one column. In this form, you'll always find Assets listed first, and then they're followed by Liabilities and Equity.

1. Assets

Assets are what a company owns. It’s basically everything that can generate money or economic benefits for the company in the future. The term "Assets" is derived from the idea that these items hold value and contribute to the overall wealth or financial well-being of the entity.

Current Assets:

Current Assets are items owned by a person or a company that are expected to be converted into cash or used up within one year. They are vital for immediate needs and covering short-term expenses.

Here are the key examples of Current Assets: 

• Cash and cash equivalents: This is like cold hard cash in your wallet you can use right away to buy what you need. You can also think of it as money in your bank account that you can easily access, you can grab cash whenever you need it.

• Accounts receivable: They're not cash yet, but you expect to get the money soon. Remember when your friends promise to pay you back after eating out together, those promises are like "Accounts receivable".

• Inventory: This includes raw materials, work-in-progress, and finished goods ready to be sold. Imagine them as goods on the shelves of a store, just waiting to be purchased.

Non-current assets:

Unlike Current assets readily convertible to cash, Non-current assets like houses or cars require longer holding periods, exceeding one year. Their primary purpose is not short-term expense coverage but rather long-term wealth generation through strategic investments.

Here are the key examples of Non-current assets: 

• Property, plant, and equipment: This is like the permanent stuff you need to run your business. If you sell lemonade, then Property is the land your stand sits on or  Equipment is your blender.

• Intangible assets: These are things you can't touch but are super valuable for your business, like your secret lemonade recipe or a cool logo for your lemonade stand.

• Long-term investments: These are things you buy now that will help your business grow in the future, like saving up to buy a bigger blender or maybe even a truck to sell lemonade at different places.

Now if you are running your lemonade business, let’s look at the example for Assets:

Current assets:

• Cash and cash equivalents: $10 in your pocket (readily available cash).

• Accounts receivable: $15 owed by friends who haven't paid for their lemonade yet (money coming soon).

• Inventory: $5 worth of lemons, $2 worth of sugar, and $10 worth of cups.

Non-current assets:

• Property, plant, and equipment (PPE): $20 for your table and umbrella

• Long-term investments: $25 saved up for a bigger blender

2. Liabilities  Liabilities are what a company owes to other parties that are not their owner/shareholders. It could be money borrowed from a bank, or money it owes to suppliers for things it bought but hasn't paid for yet. This is utilized as assets to fund business activities and business will have to pay it back later.

Current liabilities: 

Current liabilities are short-term debts or obligations (due within a year) that the company needs to pay promptly.

Here are the key examples of Current liabilities. For simple understanding, let consider the each example under the view of your lemonade business:

• Accounts payable: They're not immediate debts you have to pay right away, but you need to pay them back soon.

• Wages payable: It's money you owe someone for their work. Your friend helped you run the stand for the afternoon, and you promised to pay them later. That's "wages payable".

• Taxes payable:  This money belongs to the government, think of it as a bill you owe to the "lemonade inspector" and you need to pay later.

Non-current liabilities: 

Non-current liabilities are obligations that are not expected to be settled within one year. These are long-term financial commitments that extend beyond a year.

Here are the key examples of Non-current liabilities:

• Long-term loans: This is the debt you'll settle over a longer period. Imagine needing a bigger blender but not having enough money. You might ask your parents for a larger loan, something you'll pay back over several weeks or even months. That's a long-term loan.

• Bonds payable: It's a long-term debt you'll gradually pay back but with interest, kind of like getting a big loan from many people at once.

Here's how your liabilities might look in real example:

Current liabilities:

• Accounts payable: $20 owed to the grocer for lemons and sugar (need to pay within a week).

• Wages payable: $10 owed to your friend for helping out (need to pay by the end of the day).

• Taxes payable: $5 collected in sales tax (need to send to the government within a month).

Non-current liabilities:

• Short-term loan: $50 borrowed from your parents to buy a new pitcher (will pay back in 2 months).

• Long-term loan: $100 borrowed from your aunt to buy a fancy cart (will pay back in 1 year with interest).

3. Equity Equity is the portion of the company owned by shareholders or investors. It represents the value of investment from shareholders in the company and is also used as a funding for operating.

Here are common examples of Equity in a Balance Sheet: 

• Shareholder Equity: It represents the residual claim of shareholders on the company's assets after all liabilities are paid off. If you decide to expand your lemonade stand and bring in your friends, you could give them partial ownership. The total value of their shares would represent Shareholder Equity on your balance sheet.

• Retained Earnings: This represents the portion of a company's profits that are not paid out as dividends to shareholders but instead reinvested back into the business.  So if you choose to use any profits you make from selling lemonade to buy more ingredients, expand your stand, or invest in better equipment, they are Retained Earnings.

Balance Sheet example Let's drive down a simple lemonade stand balance sheet:

Assets:

Cash          : $10 (initial investment)

Accounts receivable: $15

Inventory:  $5 worth of lemons, 

                       $2 worth of sugar, 

                       $10 worth of cups.

Property, plant, and equipment (PPE): $20

Long-term investments: $25

Total Assets: $117

Liabilities:

Accounts payable: $20

Wages payable: $10

Taxes payable: $5 

Short-term loan: $50 

Long-term loan: $100

Total Liabilities: $185

Equity: $-68

Key takeaways from the example:

• The negative equity indicates that the stand currently has more liabilities than assets. It illustrates a common scenario for start-ups with initial investments exceeding current income. It doesn't necessarily indicate failure, but highlights the need for careful financial management and growth strategies.

• As the stand sells more lemonade and collects payments, its assets will increase, leading to a positive equity. This emphasizes the importance of generating revenue and managing cash flow effectively.

• The example also demonstrates the importance of maintaining a healthy balance between different types of assets and liabilities. Having sufficient current assets to cover short-term debts is crucial for operational stability.

Keep in mind that in this case your lemonade doesn’t have a healthy balance sheet.  A healthy balance sheet will have total assets exceeding total liabilities, resulting in positive owner's equity. This indicates that the business is financially stable and has the potential for future growth.