A balance sheet summarizes a company’s financial position at a point in time. The table shows a company’s assets on the left and its liabilities on the right, where 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.
Balance sheets include three main categories: 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). It is customary to list all of a company’s assets on the left side and its liabilities and financial equity on the right side. For example, assume Tye’s Laundry holds the following assets:
Now assume Tye’s Laundry has the following liabilities:
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 becomes an asset. Assume Tye’s Laundry borrows $30,000 to buy 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 will decrease by $30,000, and the company’s washer and dryer account will increase by $30,000. In both these cases, the financial equity remains unchanged. If Tye had financed the purchase of the washers and dryers by investing his own money, the assets and financial equity balances would increase by $30,000 because his investment added $30,000 of equipment to 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 company’s value has increased by $30,000. Finally, assume that Tye generates a $10,000 profit. As an owner, he receives the profit. If he leaves the profit in the company, it would is added to the financial equity.
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.