It was a Saturday evening and my friend, Darshan and I were having coffee at a coffee shop.
We are childhood friends. He is an Architect and running his own practice.
We were chatting in general and he mentioned about his meeting with a friend who is in loan department of a bank.
Since Darshan was looking for some loan, he met his friend and that friend threw some jargons like balance sheet, revenue, profit, and many other things.
Darshan, being an Architect was totally unaware of these things and asked me about the meaning of these things.
I wanted to tell him the meaning of these terms but in a language that he will understand.
So, I started with “Balance Sheet” concept.
What is a balance sheet
Here’s how I explained balance sheet to Darshan. I present you with a snippet of our conversation.
I: “Balance Sheet is prepared for a single date; it’s not for a year.”
I: “In simple terms, the sheet which shows the balance of what your business/ or a company owes and owns is called a balance sheet.”
D: “Oh, I see. Can you please explain it more?”
I: “Sure. See, you started with initial capital of Rs. 2 lakhs. You bought computer, printer, and other things required to carry your professional work. So those are called ‘Assets’.”
D: “So everything what I spend like office rent is my asset, right?”
I: “No. Some are your assets and some are your expenses.”
D: “So, is the balance sheet consisting of only assets?”
I: “No. It has two parts. One is Assets and another is Liabilities. Whenever you create an asset, you have to invest that money out of your own capital or you need to take loan. That loan and capital are parts of liabilities. Also sometimes you take some things on credit and that forms a part of ‘current liabilities’”.
D: “Avadhut, I understood it till now. I have a doubt though. Why my capital is considered as a liability?”
I: “I am glad that you asked this question. See, your business is different from your personal matters. So, your business is a separate entity and hence you are a stakeholder in your business. So, it’s your business which owes you the capital you invested or any loan it you have taken.”
D: “Hey, that’s pretty simple thing. I never knew it would be so easy. But, where do I mention the profit of my business?”
I: “Well, whatever profit you make, you add as a ‘surplus’ to the capital. You are a shareholder in your business. In short, it’s called ‘Shareholder’s equity’. And it is calculated by subtracting total liabilities from total assets.
D: “Excellent. So, I have some cash with me and some in bank, this is my asset, right?”
I: “You are spot on Darshan. Cash is a part of liquid asset.”
D: “Thanks buddy, all these jargons are much simpler for me now. I have few more doubts but it’s time to go for dinner now, will catch you soon.”
I: “Alright buddy, see you.”
Darshan went home for dinner and I came back to my home. I could see a new-found confidence on Darshan’s face today.
Refining the Balance Sheet Concept Further
By now, you have had a basic idea of balance sheet. Let’s get into its details.
A balance sheet is a financial statement, which is one of the main components of company accounting, apart from other financial statements like stockholders’ equity statement, cash flow statement and income statement.
If any company wants to ascertain its financial position at any given date, the balance sheet represents the accurate position. Often, you see company balance sheet published in popular newspapers and that is because every shareholder (the public, in this case) has the right to know the financial health of the company they invest their money.
As such, the balance sheet of a company is of interest to various people and entities such as banks, investment agencies, company management, competitors, current stakeholders, customer, suppliers, labor unions and government institutions.
Assets and Liabilities are two parts of a balance sheet. At the end, both the assets and liabilities should balance. If it doesn't, the accounting has obviously been erroneous.
On the balance sheet, all the assets are classified as:
- Current Assets
- Property, Plant and Equipment
- Intangible Assets
- Other Assets
Assets are those resources which are owned by the company and have a certain economic value in the long-term. In the balance sheet, assets have debit balance. Note here that contra assets are also a part of Assets. It is called ‘contra’ or ‘contrary’ because these assets have credit balance.
Anyways, assets include items like inventory, cash, accounts receivables, land, buildings, goodwill, equipments, bond issue costs, supplies, petty cash, prepaid insurance and others. Items like accumulated depreciation for buildings, equipments, land improvements and doubtful accounts allowances come under contra assets.
On the balance sheet, all the liabilities are classified as:
- Current Liabilities
- Long-Term Liabilities
- Total Liabilities
- Owners’ Equity
- Total Liabilities & Owners’ Equity
Liabilities are the opposite of Assets. They are the obligations which must be fulfilled by the company, such as advances received for work or paying creditors. In the balance sheet, liabilities have credit balance. Note here that contra liabilities are also a part of Liabilities. It is called ‘contra’ or ‘contrary’ because these liabilities have debit balance.
Suggested: Read more about Finance Basics
Liabilities include payables, such as salaries, wages, accounts, warranty, lawsuits, interest, income taxes, bonds, customer deposits, unearned revenues and other accrued expenses. Items like discounts on payable bonds and notes come under contra liabilities.
You can see a sample balance sheet below.
This was just a basic outline of what a balance sheet is all about. There are further bifurcations that take place as per the assets and liability divisions undertaken by the company in question.
I hope now you understand the meaning of a balance sheet. If not, watch video on this page.