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The Balance Sheet is the financial report that shows what the business is worth at some instant in time. This lesson will focus on the Liabilities and Equity side of the Balance Sheet.
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Quick reference
Balance Sheet Part 3
The Balance Sheet is the financial report that shows what the business is worth at some instant in time. This module will focus on the Liabilities and Equity side of the Balance Sheet.
When to Use Balance Sheets
The Balance Sheet is normally calculated whenever financial reports are prepared and submitted to investors or senior management. It is useful for tracking liquidity and debt.
Instructions
- Unlike the other major financial reports, the Balance Sheet is for an instant in time, not a period of time.
- The Balance Sheet shows what the company has as assets and what the company owes as liabilities – the difference is the owner’s equity or the net worth of the company.
- The Balance Sheet indicates what types of liabilities a company has – debt, unpaid bills, etc.
- The typical categories of liabilities are listed, some company’s will further subdivide these categories:
- Accounts Payable – this is the money owed to suppliers. When using the accrual basis, an invoice is received for goods and services. Until the invoice is paid, the amount of the invoice is in the Accounts Payable. It is often referred to as a current liability because it is assumed that the bill will soon be paid.
- Short-term Debt – this is debt that must be paid within less than one year from the time the debt was negotiated. It is typically used for lines of credit, credit card debt, or short term “bridge” loans. It is also referred to as a current liability.
- Long-term Debt – this is debt that must be paid over a time period that exceeds one year from the time the debt was negotiated. It is usually used for mortgages and company-issued bonds.
- An unusual category of liability that is sometimes shown is Progress Collections. In some businesses, customers pay for a product up-front, before it has been manufactured or delivered. These payments are shown as a liability until the product is sold, since if the company does not deliver the product, they are normally obligated to return the payment. The Progress Collection account keeps the Balance Sheet balanced. When the down payment was received, the Cash value on the Asset side of the Balance Sheet went up, but inventory did not go down delivering a product. Therefore something on the Liabilities and Equity side had to go up also and the Progress Collections account is what is used to identify that money.
- The value on the Balance Sheet of Equity is the value of the company – at least on paper – and is sometimes called book value. This value can be determined by taking the value of the Assets and subtracting the Liabilities.
- The market value of a company is often quite different from the Balance Sheet Equity because the market will assign value to expected future sales, profits, or opportunities, whereas the Balance Sheet only includes what has already happened in the past.
- There are two categories of Equity, but these are normally divided into further subcategories:
- Owner’s Investment – this is the value of the money provided to the company by the original investors and the value of the money received from any stock offerings. It is not the current value of the stock – which fluctuates daily.
- Retained Earnings – When a company makes a positive Net Income, it often provides a portion of that Net Income to the owners as dividends, but it retains a portion of that income to reinvest into the company. This account is meant to represent that reinvestment. When a company loses money, or distributes dividends that are greater than the Net Income, the Retained Earnings are lowered.
Hints and Tips
- The value used for each category is normally pulled from the accounts in the company’s financial system.
- Many companies will subdivide some of the Balance Sheet accounts to show specific categories of liabilities or equity.
- For example: payables may be divided into payables to suppliers, payables for taxes, and payables of dividends for shareholders.
- 00:03 Hi this is Ray Sheen, it's time to talk once more about the balance sheet.
- 00:07 This time, I'll focus on the liability and equity sign.
- 00:12 Recall that the right side of the balance sheet, is the side showing liability and
- 00:16 owners equity.
- 00:17 Also remember that the balance sheet is always balanced.
- 00:20 So the sum of those two will equal the sum of the assets.
- 00:24 Another way of putting this is to say a portion of the value of the company's
- 00:27 assets.
- 00:27 Will be allocated to pay any debts, and
- 00:30 the remaining value will be allocated to the owners.
- 00:33 Let's start with a quick overview of both of those.
- 00:36 The liabilities are the companies debts.
- 00:38 The money owed to suppliers or
- 00:40 to financial institutions from which the company borrowed money.
- 00:44 The equity is the remaining value of the assets
- 00:46 that is owed to the owners of the company.
- 00:49 If all the assets were sold off and the debts were paid off.
- 00:52 This is the money that the owners would be dividing among themselves.
- 00:56 Let's dig deeper into the liabilities portion of the balance sheet.
- 01:00 Liabilities are the actual debts of the company.
- 01:03 The company owes money to another organization, company, or individual.
- 01:08 One type of debt is the money that is owed to suppliers for goods and
- 01:11 services that they have provided.
- 01:14 This is called accounts payable.
- 01:16 You can think of it as the reciprocal of the accounts receivable,
- 01:19 that we talked about in assets.
- 01:21 In that account we were waiting for money owed to us by our customers.
- 01:24 In this account,
- 01:25 we have recorded the amount of money that is owed to our suppliers.
- 01:30 This account only exists when a company uses the accrual method for accounting.
- 01:34 They receive the goods and services along with a bill.
- 01:37 The value for the bill goes into this account.
- 01:39 When the bill is paid, cash comes out of the cash account.
- 01:43 And the bill is erased from this account.
- 01:45 If you have long payment terms with your suppliers,
- 01:47 this account can become very large.
- 01:50 Next is short term debt.
- 01:52 This is money that is borrowed, and is due to be paid back within a year.
- 01:56 In most small companies, this is their credit line and credit cards.
- 02:00 Long term debt is debt that was set up with more than a year to pay.
- 02:04 Whether it is short term or long term.
- 02:06 the debt is owed to the financial institution
- 02:08 that provided cash to the company.
- 02:10 Normally, the company must also pay interest on the balance of the debt.
- 02:14 The interest is not part of the balance sheet.
- 02:16 But it is reflected in the earning statement, and the cash flow statements.
- 02:20 Before I move on, there is another type of liability that occasionally occurs.
- 02:25 This is often referred to as progress payments or collections.
- 02:30 This is essentially an up front payment by a customer for work that has not yet
- 02:34 been started.
- 02:35 Think of it as a down payment.
- 02:37 This brings cash into the business.
- 02:39 But it is a liability because the business is obligated to deliver the goods or
- 02:43 services for which the money was paid.
- 02:46 On to the equity portion of the balance sheet.
- 02:48 Equity is the value of the company left over,
- 02:50 after subtracting the liabilities from the assets.
- 02:53 It is sometimes referred to as the book value of the company.
- 02:56 Because if we do the subtraction, that is the value of the company.
- 03:00 According to the financial records of the company.
- 03:02 It is possible to have a negative equity.
- 03:04 If the liabilities are greater than the assets, then equity is negative.
- 03:09 One other clarification, the equity value or
- 03:11 book value of a company is often much less than the market value.
- 03:15 The market value is based upon the number of outstanding shares
- 03:18 times the price per share.
- 03:20 It's not uncommon to find that the value is well above the book value.
- 03:23 Why's that?
- 03:25 Well, the market value considers things like market share, growth potential.
- 03:29 The market sets its price based upon what it believes is the future of the company.
- 03:34 The book value is based upon what has happened in the past.
- 03:37 There are two broad categories for equity on the balance sheet.
- 03:41 The first is Owner's Investment.
- 03:43 This is the money paid into the company by the owners.
- 03:45 It would include money from the founders, the venture capitalists.
- 03:49 And even the money from an IPO, if it is a publicly traded stock.
- 03:53 This may be divided into several sub accounts to reflect
- 03:56 different types of stock or investment.
- 03:58 The second category of equity is the retained earnings.
- 04:01 Think back to the earning statement for a minute.
- 04:04 The bottom line of that statement was the profit or loss to the company.
- 04:07 A portion of the profit is often sent to the owners as dividend distributions.
- 04:12 However, many companies allocate a portion of the profit to reinvest back into
- 04:15 the company.
- 04:16 This is called retained earnings.
- 04:21 Liabilities and equity, are the value of the company.
- 04:23 That is owed to others, either vendors, lenders, or the owners.
- 04:28 Liability and equity always equals the value of the assets.
- 04:32 That's how the balance sheet stays balanced.
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