Part 1, Lesson 2

What is a balance sheet?


A balance sheet is one of three financial statements that every company produces to convey information regarding its financial picture.  The other two financial statements are the income statement and cash flow statement.  The balance sheet is a snapshot of a business at a particular moment in time, whereas the income statement and cash flow statements convey information over a particular period of time.

The balance sheet consists of Assets, Liabilities, and Shareholders’ Equity and follow the rule:

Assets = Liabilities + Shareholders’ Equity

The balance sheet is a generally accepted format that displays all the asset accounts of the business on one side vs. all the liabilities and equity accounts on the other side.  For a company to purchase an asset, it must be funded by taking on a liability or by accepting equity into the business.  For example, if you want to buy a home (the asset), it must come from either a mortgage (liability) or your own cash (equity).  For this reason, the assets of a business must always “balance” with the liabilities and equity.

John’s Pizzeria – Let’s Create a Business and a Balance Sheet


The easiest way to understand the construction of a balance sheet is simply to see one created from scratch.  Below, we will walk through the creation of a business, John’s Pizzeria, and walk through several simple transactions in order to build on our initial balance sheet.

Step 1 – Fund the Business with Equity
To start John’s Pizzeria, John will need cash to pay for inventory, rent, salaries, etc.  So where can the initial cash for a business come from?  There are two primary sources – 1) Equity and 2) Debt.  If John decides to invest his personal savings into the business, then his initial funding will come in the form of equity.

Let’s say John decides to fund the business with $100,000 of his savings and he creates his business on December, 31, 2018.  Below is what our initial balance sheet would look like:

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets Liabilities
Cash $100,000
Shareholders’ Equity
John’s Equity $100,000
Total Assets $100,000 Total Liabilities and Equity $100,000

 

Note the following important points in the construction of our initial balance sheet:

  • Balance sheets are always shown as of a specific date. In this case, we have shown the balance sheet “As of December 31, 2018.”  Most public companies will report their balance sheet as of the last day of each calendar quarter (March 31st, June 30th, Sept 30th, Dec 31st).
  • Assets are shown on the left side of the balance sheet and Liabilities and Equity are shown on the right side of the balance sheet. Many public companies may format the balance sheet by showing Assets on top and then Liabilities and Equity underneath Assets, but for now, it is helpful to think of Assets being on the left side of the scale and Liabilities and Equity as being on the right side of the scale.
  • The left side of the balance sheet will always equal the right side of the balance sheet. In other words, Assets = Liabilities + Equity.
  • For a balance sheet to balance, any input on one side of the balance sheet must have a corresponding input on the other side of the balance sheet.
  • Therefore, if we increase “John’s Equity” by $100,000, then, there must be a corresponding increase in Assets to keep the balance sheet balanced.
  • In this case, John’s funding of $100,000 will show up in his business bank account as Cash, so we create a Cash line item under Assets to show where that $100,000 went.

 

Step 2 – Fund the Business with Short-term Debt
Let’s now imagine that John decides to take a loan from the bank to raise additional capital for his business.  John decides to borrow $50,000 due in less than 12 months.  Short-term is considered anything less than 12 months, whereas long-term is considered anything longer than 12 months.  This is true for both liabilities and assets.

Therefore, this loan will show up below as “Short-Term Debt.”  Once you begin reading real-world balance sheets, you will notice that different companies use different labels to describe the same thing.  Some companies may label their short-term debt as “Debt due within 12 months” or “Revolving Credit Facility” or “Short-term indentures.”  The terminology used simply depends on the preference of the company and the underlying specificities of the debt in question.

Let’s update John’s Balance sheet, assuming he takes the loan at the same time he funds the business with equity:

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets Liabilities
Cash $150,000 Short-Term Debt $50,000
Shareholders’ Equity
John’s Equity $100,000
Total Assets $150,000 Total Liabilities and Equity $150,000

 

Note the following updates to the balance sheet:

  • We added “Short-Term Debt” to the right side of the balance sheet in the amount of $50,000.
  • By increasing Liabilities by $50,000, we must have a corresponding $50,000 increase to Assets for the balance sheet to balance.
  • The corresponding $50,000 increase will go into cash.
  • We update the sum totals to show that the Total Assets are now $150,000, which has been funded by $50,000 in Liabilities and $100,000 in Equity.

 

Step 3 – Fund the Business with Long-term Debt
Let’s now assume that John decides to fund his business with long-term debt.  This refers to any debt that is not due for the next 12 months.  Let’s update John’s Pizzeria’s balance sheet to show $70,000 in long-term debt:

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets Liabilities
Cash $220,000 Short-Term Debt $50,000
Total Short-Term Liabilities $50,000
Long-Term Debt $70,000
Total Long-Term Liabilities $70,000
 
Total Short and Long-Term Liabilities $120,000
Shareholders’ Equity
John’s Equity $100,000
Total Assets $220,000 Total Liabilities and Equity $220,000

 

Step 4 – Purchase Furniture, Fixtures, and Equipment
For John to operate a pizzeria, he must buy furniture such as tables and chairs and equipment such as a pizza oven.  Let’s assume that John purchases $60,000 worth of “Furniture, Fixtures, and Equipment” using cash.

Similar to liabilities, we should think of Assets as being “Short-Term” or “Liquid Assets” vs. “Long-term” or “Fixed Assets.”  Short-term assets are assets that are considered to have a useful life less than 12 months or expected to be consumed within 12 months.  Cash is categorized as a short-term asset because it can be consumed anytime (ie, it is a liquid asset).

Assets that have a useful life of longer than 12 months are considered a “Long-Term Asset” or “Fixed Asset.”  These terms are often used interchangeably.  One of the most common long-term assets is “Furniture, Fixture, and Equipment” which is often used interchangeably with “Property, Plant, and Equipment.”

Let’s update John’s Pizzeria’s balance sheet:

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets Liabilities
Cash $160,000 Short-Term Debt $50,000
Total Short-Term Assets $160,000 Total Short-Term Liabilities $50,000
Furniture, Fixtures & Equipment (“FF&E”) $60,000 Long-Term Debt $70,000
Total Long-Term Assets $60,000 Total Long-Term Liabilities $70,000
 
Total Short and Long-Term Liabilities $120,000
Shareholders’ Equity
John’s Equity $100,000
Total Assets $220,000 Total Liabilities and Equity $220,000

 

Note the following updates to the balance sheet:

  • In this instance, we are reducing the cash balance by $60,000. To balance, this $60,000 reduction in cash must be offset by a corresponding $60,000 increase in an asset (or a $60,000 reduction in a liability or a $60,000 reduction in equity).
  • Since this $60,000 of cash is being used to purchase Furniture and Equipment, we then increase the FF&E line item by $60,000.
  • Notice that we have now also created categories for short-term assets and long-term assets.

 

Step 5 – Purchase Inventory
Now that John has furniture and equipment ready to go, he must purchase inventory that he can then sell to potential customers.  For simplicity, we will assume that John is purchasing ready-made frozen pizzas for sale in his business.  This avoids us having to account for the various ingredients that go into the creation of a pizza.

Let’s assume that John purchases 1000 frozen pizzas for $10 each for his initial inventory on December 31, 2018:

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets Liabilities
Cash $150,000 Short-Term Debt $50,000
Inventory $10,000
Total Short-Term Assets $160,000 Total Short-Term Liabilities $50,000
Furniture, Fixtures & Equipment (“FF&E”) $60,000 Long-Term Debt $70,000
Total Long-Term Assets $60,000 Total Long-Term Liabilities $70,000
 
Total Short and Long-Term Liabilities $120,000
Shareholders’ Equity
John’s Equity $100,000
Total Assets $220,000 Total Liabilities and Equity $220,000

 

Note the following updates to the balance sheet:

  • We have added a new line item “Inventory” to account for purchase of $10,000 of frozen pizza inventory.
  • To pay for this inventory, John is using cash, so we have decreased cash by a corresponding $10,000.

 

Step 6 – Purchase Supplies
John must now purchase various supplies for use in his pizzeria.  This could include paper plates, napkins, utensils, etc.  Let’s assume that John purchases $5,000 worth of supplies from his distributor, but the distributor is giving John 30 days before having to pay for these items:

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets Liabilities
Cash $150,000 Short-Term Debt $50,000
Inventory $10,000 Accounts Payable $5,000
Supplies $5,000    
Total Short-Term Assets $165,000 Total Short-Term Liabilities $55,000
Furniture, Fixtures & Equipment (“FF&E”) $60,000 Long-Term Debt $70,000
Total Long-Term Assets $60,000 Total Long-Term Liabilities $70,000
 
Total Short and Long-Term Liabilities $125,000
Shareholders’ Equity
John’s Equity $100,000
Total Assets $225,000 Total Liabilities and Equity $225,000

 

Note the following updates to the balance sheet:

  • We increased the line item “Supplies” by $5,000. John could have paid for these supplies with cash and decreased the cash balance by $5,000.  But instead, we created an “Accounts Payable” line item to show that John still owes this $5,000 to his distributor.
  • It is important to understand the difference between debt and accounts payable. Although debt and accounts payable are both amounts owed to someone else, debt is typically owed to a lender or bank and must be repaid with interest.  However, accounts payable are typically representative of amounts owed to vendors for the purchase of goods and services that have simply not been paid for yet.  Accounts payable are almost always short-term liabilities (no vendor wants to wait 12+ months to get paid for their goods and services!).