A balance sheet is one of three primary financial statements, along with the income statement and cash flow statement, used to evaluate the financial health of an entity at a given moment in time. It consists of three primary sections: assets, (what the entity owns); liabilities, (what the company owes); and shareholders equity, the difference between what the companies owns and what it owes. Since shareholders equity is the difference between the two, the balance sheet equation is: Assets = Liabilities + Shareholders Equity. In plain English, everything the entity owns is either obtained borrowing money (i.e. creating a liability) or by being owned outright by the company’s shareholders (i.e. owners).
The balance sheet must always balance, that’s what it is called a balance sheet! As a result, by definition, any corporate transaction which impacts the balance sheet must impact TWO ledgers in order to ensure the balance sheet balances. For example, if a company borrows cash from the bank it’s cash asset will increase, and so will its liabilities, in the form of a loan. Assets and liabilities will increase by the same amount, shareholders equity is unchanged, and the balance sheet still balances.
Knopman Notes:
A balance sheet can be used by both businesses and individuals. When analyzing a business’ balance sheet, an investment banking practitioner can get a good sense of the companies’ leverage (liabilities vs. shareholders equity), liquidity (cash vs. short-term loans) and net worth (shareholders equity).
For individuals, investment advisers will often help a client build their personal income to recommend a suitable financial plan. For example, an investor who has lots of illiquid assets (e.g. house or car) but lots of short-term debt (e.g. credit card debt) should make sure to keep cash in their portfolio to pay off that debt. On the other hand, an investor without any short-term debt (sometimes called current liabilities) may be able to invest in more illiquid securities, such as hedge fund units.
Relevant Exams:
Series 7, Series 65, Series 66, Series 79
