A Straightforward Explanation of a Company’s Balance Sheet

By Randall Orser | Small Business

Balance Sheet Word Cloud Concept in red caps TNA company’s balance sheet is one of its three main financial reporting methods. The other two include the company’s income statement and its cash flow statement. However, if ever there was one way to describe a balance sheet, it would have to be that a company’s balance sheet is simply a snapshot in time and must always be in “balance”. What exactly does this mean? Well, it means that both sides of the ledger must be equal to one another. It is a single moment in the company’s history that summarizes the company’s assets, liabilities and owner’s equity. In fact, to make sure the balance sheet is in balance, it must follow one simple rule; the company’s assets must equal its liabilities and owner’s equity. We’ll review this simple rule and show how a company must ensure that its balance sheet is a true representation of its assets, liabilities and owner’s equity.

The Balance Sheet Rule: Assets = Liabilities + Owner’s Equity

Understanding assets, liabilities and owner’s equity

In order to understand the balance sheet, it’s important to define these three aforementioned criteria. A company’s assets include its cash, inventory, equipment and machinery in addition to any real estate holdings. It is found on the left side of the balance sheet. A company’s liabilities are a summary of what it owes to in notes payable and a summary of owner’s equity. The liabilities are always found on the right side of the balance sheet. We’ll take a systematic approach to defining all three of these criteria within the balance sheet by approaching it from the mindset of a company that is just getting started. Along the way, we’ll fill in the gaps in the following table and outline exactly how the balance sheet must always be in balance.

Assets Liabilities
cash notes payable
inventory owner’s equity original investment
equipment and machinery
total assets: total liabilities:

Your first week of operation!

Let’s assume you’ve decided to pursue a new business venture. You have $1,000.00 of your own money to invest in your business. However, you need more. Therefore, you secure an initial loan from a private investor. That initial loan totals $5,000.00 and is money you can use to get your business off the ground. However, that loan isn’t cheap by any means. That investor will easily charge you interest to borrow the money. After all, they’re in it to make money as well! Therefore, you now have $6,000.00, which is made up of $1,000.00 of your own money and a $5,000.00 loan. This $6,000.00 in cash should go on the left hand side of your ledger under “assets”. However, you also have a loan that should go under the notes payable section of your liabilities side, in addition to your own original investment of $1,000.00 that should go under the owner’s equity portion. These changes have been included below and are in blue. The balance sheet is now in balance. Looking at the table below, it’s easy to see how the balance in the balance sheet is maintained. You have cash holdings of $6,000.00 and liabilities of $6,000.00. We’ll consider this balance sheet a representation of your first week of operating a business.

Week 1: Balance Sheet

Assets Liabilities
cash $6,000.00 notes payable $5,000.00
inventory owner’s equity

  • original investment $1,000.00
equipment and machinery
total assets: $6,000.00 total liabilities: $6,000.00

Your second week of operation

In your second week, you move forward with purchasing inventory and equipment in order to get your business off the ground. When thinking of inventory, think of supplies for your business. It’s the same thing. You decide to purchase raw materials that total $4,000.00 in order to make your product. You also purchase a computer system for your new business that costs $1,000.00.

These aforementioned amounts come directly from cash in assets. This means you must place the above amounts under the inventory and equipment portion of the assets side of the ledger. Since you’ve spent this money, you must deduct it from your cash. Therefore, you now have $1,000.00 in cash, $4,000.00 tied up in inventory and $1,000.00 in equipment.

Does the liabilities portion of the balance sheet change? No. You still owe your original loan and still have your original investment of $1,000.00. All you’ve done in this step is account for the inventory and equipment you’ve purchased. The table below is a representation of the balance sheet for the second week of operation.

Week 2: Balance Sheet

Assets Liabilities
cash $1,000.00 notes payable $5,000.00
inventory: $4,000.00 owner’s equity

  • original investment $1,000.00
equipment and machinery: $1,000.00
total assets: $6,000.00 total liabilities: $6,000.00

Your third week: making a sale!

Up to this point, you’ve simply allocated your expenditures in terms of inventory and equipment. Now you’re ready to start making some sales. In this case, you need to determine your product’s “COGS”, which is simply an acronym for “cost of goods sold”. Your new company is able to make 100 units of your new product from the inventory you’ve purchased. Therefore, your COGS are $40.00 per unit which is simply the $4000.00 of inventory divided by the 100 units that can be made from that inventory.

After doing some market research, you determine that you should be able to sell each product for $55.00. Your gross profit is simply your sales total of $55.00 minus the $40.00, giving you a gross profit of $15.00 for each unit sold. In the first week of operation, you manage to sell 60 units for a sales total of $3,300.00 (60 units multiplied by $55.00 per unit). Your total costs are 60 units multiplied by the $40.00 in COGS, which is $2,400.00. This means you’ve generated a gross profit of $900.00, which is simply the sales revenue of $3,300.00 sales minus your total costs of $2,400.00.

For this transaction, we have to add the $3,300.00 of sales revenue into the cash portion of the balance sheet. Our new total in cash is now $4,300.00. Our inventory has been reduced by $2,400.00, which now leaves us with a total of $1,600.00 in inventory. Unfortunately, if we were to stop here, the assets would be larger than the liabilities, and that simply can’t be the case. Remember, both sides must equal each other and must be balanced. So, we add a new category to the liabilities of the ledger portion to include the gross profit we generated for the sale of 60 units in your first week of operation. This new category must go under the owner’s equity portion of the liabilities side. Here is a representation of the entire transaction.

Week 3: Balance Sheet

Assets Liabilities
cash $4,300.00 notes payable $5,000.00
inventory: $1,600.00 owner’s equity

  • original investment $1,000.00
  • earnings: $900.00
equipment and machinery: $1,000.00
total assets: $6,900.00 total liabilities: $6,900.00

From this point on, you’ll continue to invest in your business. Perhaps in your fourth week of operations you’ll start advertising or marketing your product to new prospects. If so, those expenses will come directly from your cash holdings on the asset side and be deducted from your earnings portion on the liabilities side. Over time you’ll want to pay off your loan under your liabilities. Each time you do, you’ll reduce the left side of the ledger by the same amount. Remember the rule with respect to the balance sheet: The right side must always equal the left.

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