A balance sheet describes the resources that are under a company’s control on a specified date and indicates where these resources have come from. It consists of three major sections: (1) the assets: valuable rights owned by the company; (2) the liabilities: the funds that have been provided by outside lenders and other creditors in exchange for the company’s promise to make payments or to provide services in the future; and (3) the owners’ equity: the funds that have been provided by the company’s owners or on their behalf.
The list of assets shows the forms in which the company’s resources are lodged; the lists of liabilities and the owners’ equity indicate where these same resources have come from. The balance sheet, in other words, shows the company’s resources from two points of view, and the following relationship must always exist: total assets equals total liabilities plus total owners’ equity.
This same identity is also expressed in another way: total assets minus total liabilities equals total owners’ equity. In this form, the equation emphasizes that the owners’ equity in the company is always equal to the net assets (assets minus liabilities). Any increase in one will inevitably be accompanied by an increase in the other, and the only way to increase the owners’ equity is to increase the net assets.
Assets are ordinarily subdivided into current assets and noncurrent assets. The former include cash, amounts receivable from customers, inventories, and other assets that are expected to be consumed or can be readily converted into cash during the next operating cycle (production, sale, and collection). Noncurrent assets may include noncurrent receivables, fixed assets (such as land and buildings), and long-term investments.
The liabilities are similarly divided into current liabilities and noncurrent liabilities. Most amounts payable to the company’s suppliers (accounts payable), to employees (wages payable), or to governments (taxes payable) are included among the current liabilities. Noncurrent liabilities consist mainly of amounts payable to holders of the company’s long-term bonds and such items as obligations to employees under company pension plans. The difference between total current assets and total current liabilities is known as net current assets, or working capital.
The owners’ equity of an American company is divided between paid-in capital and retained earnings. Paid-in capital represents the amounts paid to the corporation in exchange for shares of the company’s preferred and common stock. The major part of this, the capital paid in by the common shareholders, is usually divided into two parts, one representing the par value, or stated value, of the shares, the other representing the excess over this amount. The amount of retained earnings is the difference between the amounts earned by the company in the past and the dividends that have been distributed to the owners.
A slightly different breakdown of the owners’ equity is used in most of continental Europe and in other parts of the world. The classification distinguishes between those amounts that cannot be distributed except as part of a formal liquidation of all or part of the company (capital and legal reserves) and those amounts that are not restricted in this way (free reserves and undistributed profits).
Table 1A simple balance sheet is shown in Table 1. Because the two sides of this balance sheet represent two different aspects of the same entity the totals must always be identical. Thus, a change in the amount for one item must always be accompanied by an equal change in some other item. For example, if the company pays $40 to one of its trade creditors, the cash balance will go down by $40, and the balance in accounts payable will go down by the same amount.