Balance Sheet – Definition
A balance sheet is a list of assets and claims over a business at some specific point of time and is prepared from an adjusted trial balance. It shows the financial position of business by detailing the sources of funds and the utilization of these funds. A balance sheet shows the assets and liabilities grouped, properly classified and arranged in a specific manner. The balance sheet is a component of final accounts.
The balance sheet reflects the fundamental accounting model which describes the financial position of a firm in terms of equality between its assets on one side and its liabilities plus owner’s equities on the other (A = L + OE).
Hence, the balance sheet is a widely used term but is somewhat less descriptive than the more appropriate designation, statement of financial position. Assets are economic resources and benefits owned by an entity, valued generally at acquisition cost less accumulated write-offs.
Liabilities are the debts of the entity and other claims against its assets which may oblige the firm to provide goods are services. Usually, Liabilities are measured at their current cash equivalent or the maturity value of debt.
Owner’s equities are the residual amounts, A – L = OE, but bear little resemblance to the current market value of an entity.
Let’s take an example to better understand the balance sheet and the terms used while preparing it.
John is a bookseller. His shop, called John Book Center, is situated in close proximity to a polytechnic, an intermediate college, two secondary schools and two primary schools. He deals mainly in educational books and stationery. He generally sells books only on a cash basis but occasionally extends credit to certain reliable customers particularly if a school wishes to buy books from him in a significant quantity. Similarly, he buys books from his suppliers mostly on cash terms but certain publishers offer him credit facilities. His premises are rented, but all the furniture, fittings and equipment in the shop are his own.
On 31 March this year, he estimated that:
- the value of unsold books and stationery in his shop was $37,250.
- he was owed $6,140 by his customers whom he had sold books on credit.
- his furniture and fittings (for example his table, chairs, bookcases and shelves. etc.) were worth $12,400; his photo-copying machine was worth $45,000 and his typewriter was worth $13,800.
- he owed $19,500 to certain publishers from whom he had bought books on credit.
- his cash box had $1,660 in it while the bank account that he operated under his shop’s name had a balance of $8,250 in his favor.
- two years ago he had started his business with the help of a $100,000 loan from SME Bank Ltd. (SME); half of this loan was still unpaid on 31 March.
The above information relating to John’s business unit, namely John Book Centre, can easily be described as a sort of summary of its financial position on the given date, that is 31 March this year. It shows what it has, what it is owed and what is owed by it to others. Let us examine this a bit closer.
Unsold books and stationery (i.e. the shop’s stock-in-trade), furniture, fittings and equipment, amounts owed to the shop by its customers (i.e. its debtors), cash in till box, cash at business bank account – all these are the things of value that John Book Center owns and uses in the conduct of its affairs. These things are called assets. Every business unit must have some assets in order to be able to do business. It is unthinkable for someone to be doing business without having anything to sell, anywhere to sell from, anything to sell with or anything to sell by. Assets are therefore essential for the conduct of every business. Let us list John Book Center’s assets and find out their total value.
In addition to the above assets, it is quite possible that John may have certain other personal assets as well (for example his household things, his personal car, cash in his personal bank account, etc.), but here we are concerned only with John Book Center’s assets, so any asset not belonging to John Book Center even if they belong to John as a person is to be ignored.
John Book Center owes some amounts to outsiders, namely $19,500 to its credit suppliers and $50,000 to SME Bank Ltd. (SME). Amounts owed by a business to outsiders are called liabilities. While it is theoretically possible that a business unit may have absolutely no liabilities to outsiders, in practice it is rare that a business establishment will transact all its affairs strictly on cash terms and thus avoid having any liabilities. Hence, almost all business has some liabilities at any given time. The total of John Book Center’s liabilities is $69,500.
3. Net Worth
It is apparent from the above that John Book Center’s total assets (worth $124,500) are greater than its total liabilities (amounting to $69,500) by $55,000. This amount represents the worth of the business. If, for example, all the assets of John Book Center were sold, a total of $124,500 will be realised. Out of this amount must be paid the liabilities owed by the business unit viz. $69,500, leaving a net balance of $55,000.
The excess of a business unit’s assets over its liabilities at any given time is called its Net Worth. This fact can be easily shown in the form of the following equations:
Assets – Liabilities = Net Worth
A – L = N.W
N.W = A – L
A = N.W + L
L = A – N.W
Now we are able to prepare a balance sheet of John Book Center with the help of the above facts and figures. As we studied earlier in this article:
“Assets, Liabilities and Net Worth of a business, at any given time, can be arranged in the form of a statement which is called Balance Sheet”.
By definition, a balance sheet is a statement that shows the financial position of a business (or a person) at a given time, expressed in the terms of assets, liabilities and net word. It is important to note that a Balance Sheet is a statement prepared as at a particular time and it is true only at that particular time. This is so because of the composition of a business unit’s assets, liabilities and net word keep on changing continuously. For example, a minute after the above statement was prepared, it is possible that a cheque was issued to one of the creditors thereby reducing cash at bank (and total assets) as well as reducing the amount owed to suppliers (and hence total liabilities). Later in this article, we will see the impact made by various transactions on the Balance Sheet of a business firm.
The Nature of Net Worth
The excess of a business unit’s assets over its liabilities represents its net worth. One may ask here: who does the business unit belong to? The answer, you may say, is pretty obvious: to its owner of course. This is correct. So we can say that because a business unit belongs to its owner, its net worth also belongs to its owner. Another question that may arise here is: how does this net worth arise, i.e. how does a business come to have more assets than liabilities? The answer to this question is also very obvious: it is because the owner of the business has invested his personal funds in the business. It follows therefore that the excess of a business unit’s assets over its liabilities actually represents the investment made in it by its owner or owners.
Any money invested in a business with a view to earn profits is called Capital. The net worth of any unit is the excess of the value of its assets over liabilities. It belongs to its owner and is therefore equal to the owner’s capital. So we now have two names for seemingly the same thing: Net Worth and Capital. Both are equal in amount but their meaning is slightly different. Net Worth is a term used in relation to a business unit’s position whereas Capital is a term used when referring to the owner’s interest in the business unit. In the case of the above Balance Sheet, we can say that John Book Center has a Net Worth of $55,000 while John has a capital of $55,000 invested in John Book Center. Let us take another example to further elaborate on the difference in the meaning of Net Worth and Capital.
Harry and Barbara started a business with the former contributing $50,000 and the latter $30.000 in cash. They also borrowed $40,000 from the Agricultural Development Bank (ADB). From the total amount thus raised, they have just bought a piece of land for $1,00,000 and the rest of the money has been deposited in the bank. Their business will be called H&B Fruit Growers and will mainly export citrus fruits. Their opening Balance Sheet will appear as follows:
The net worth of the business unit (i.e. H&B Fruit Growers) is $80,000, which is the excess of firm’s assets ($120,000) over its liabilities ($40,000). At the same time, Harry has a capital of $50,000 and Barbara has a capital of $30,000 invested in H&B Fruit Growers. In other words, H&B Fruit Grower’s Net Worth is also the total of capitals invested by the two partners, Harry ($50,000) and Barbara ($30,000).
While the two terms are often used interchangeably, it is more appropriate to say that H&B Fruit Growers has a Net Worth of $80,000 (not the capital of $80,000) and that Harry has a Capital of $50,000 (not a net worth of $50,000). Similarly, Barbara will be said to have a Capital of $30,000 (not a net worth of $30,000) invested in H&B Fruit Growers. Net Worth as a term, therefore, applies to the Business Unit, whereas Capital as a term applies to owners or owners’ interest in the business. In practice, when drawing up a Balance Sheet it is common to show the capital contributed by each owner (if there are more than one) separately rather than show only the business unit’s total worth. The above Balance Sheet will in practice be drawn up as follows:
The Balance Sheet Equation
This equation shows the composition of a Balance Sheet. It was shown earlier in this article as:
Net Worth = Assets – Liabilities
It can be restated as follows:
Capital = Assets – Liabilities
Assets = Liabilities + Capital
Liabilities = Assets – Capital
If two of the three figures making up a Balance Sheet are known, the third figure can be calculated by using the Balance Sheet Equation. For example, if assets of a business amount to $75,200 and its owner’s capital is $39,800, its liabilities can be computed as follows:
Liabilities = Assets – Capital
= 75,200 – 39,800
Similarly, if liabilities of a business are $68,100 and its ‘owner’s capital is $81, 900, its assets must be:
Assets = Liabilities + Capital
= 68,100 + 81,900
Remember, a Balance Sheet Equation is always true; it always balances.
Uses of Balance Sheet
The Balance Sheet is considered as a prominent accounting report. Various interested parties may derive different information for their own use. Generally, the following information can be derived from the Balance Sheet:
- It enables us to calculate the actual capital invested in the business.
- Creditors and lenders can ascertain the financial position of the business.
- It may serve as the basis for determining the purchase consideration of the business.
- Different ratios can be calculated from the Balance Sheet and these ratios can be utilized for better management of the business.
- The trend of working capital of the business can be determined by comparing the Balance Sheets of successive years and corrective measures can be taken, where necessary.
- It enables us to ascertain the proprietary interest of a person or business organization.
Specimen/Format of Balance Sheet
A balance sheet can be prepared in the following two formats:
Under this format, the left-hand side lists liabilities of the business as on the last day of the accounting period as well as the detail of its capital position. Various assets of the enterprise are listed on the right-hand side of the balance sheet.
Note 1: Assets of the same class are grouped together. All fixed assets together and all current assets together.
Note 2: The balance of the capital account is calculated as under:
The vertical format merely involves re-arrangement of the information shown by a balance sheet presented in the horizontal form. The vertical format clearly displays a network of the business to the owner i.e. the capital. This format also displays the amount of investment in the fixed assets and in working capital which is the difference between the current assets and current liabilities.