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Definition of a Balance Sheet:
A balance sheet
summarizes a company’s financial position at a point in time in a table showing a company’s assets on the left and its liabilities on the right. The difference between a company’s assets and liabilities is its net worth or financial equity. Financial equity is included on the right side under the liabilities so the two columns balance.
A balance sheet can be broken into three components: assets, liabilities, and financial equity. The sum of a company’s liabilities and financial equity must equal its assets since the value of a company (equity) equals the sum of its assets minus what it owes (its liabilities). For example, assume Tye’s Laundry has $700,000 in assets and $470,000 in debts. Tye has $230,000 in financial equity in the company. This is reflected on a balance sheet where all of the assets are listed on the left side, and the liabilities and financial equity are listed on the right side. The sum of the liabilities and financial equity must equal the assets. For example, assume Tye’s Laundry holds the following assets:
Land and Buildings $500,000
Now assume Tye’s Laundry has the following liabilities:
Washers and Dryers $170,000
Total Assets $700,000
Wages Payable $50,000
Taxes Payable $20,000
Equipment Loans $150,000
Mortgage Balance $250,000
Total Liabilities $470,000
Tye’s ownership interest, or financial equity, equals $230,000 (assuming Tye is the only owner).
When expressed on a balance sheet, the financial statement would be:
When a business borrows money, the loan amount is a liability, but the cash or asset purchased with the loan immediately becomes an asset. Assume Tye’s Laundry borrows $30,000 to purchase equipment. Tye’s equipment loans would increase by $30,000, but his washer and dryer’s account on the asset side of his balance sheet would also increase by $30,000. If Tye uses cash in the business to purchase the washers, Tye's Laundry's cash balance would decrease $30,000, and the company's washer and dryer account would increase $30,000. In both these cases, the financial equity remains unchanged. If Tye had financed the purchase of the washers and dryers by investing more of his own money, the assets and financial equity balances would increase by $30,000. This is because his investment adds $30,000 of equipment the company's assets. He has not borrowed any money, so Tye's Laundry's liabilities would be unchanged. The difference is reflected in the financial equity since the value of the company has increased $30,000. Finally, assume that Tye generates a $10,000 profit. As an owner he receives the profit, so the profit is added to the financial equity, assuming he leaves his profits in the company.
Investors and lenders scrutinize a company’s balance sheet to assess a company’s financial health. They compare many years to see if a company’s debt has been growing in relationship to its financial equity. They may look at the relationship between its cash position and its liabilities.
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