# Balance Sheet Equation

05 October 2022

A balance sheet is an important financial document that businesses use to understand their financial status.

By calculating and itemizing their assets—what they own—and liabilities—what they owe, they can make calculated financial decisions for the future well-being and success of their business.

More specifically, companies can subtract their liabilities from their assets to determine their net worth, which is invaluable information for investments, loan repayments, and any financial decision.

Accounting and finance professionals use many types of financial statements to determine the success of a business, including the balance sheet.

The information contained in a balance sheet provides information about the current financial status of a business and helps stakeholders make important decisions.

In this article, we'll cover what a balance is and how to create various types, as well as a template and examples.

## What is a balance?

A balance sheet is a financial statement that shows the assets, liabilities, and net worth of a business.

A balance sheet helps investors and lenders make investment and lending decisions. There are several types of balances, but the most common are:

• Classified: The most common type of balance sheet, the classified format, lists asset, liability, and equity information that is classified into subcategories of accounts.
• Common size: This format includes the same information as other sheets, but includes another column that shows the relationship of the total items of assets, liabilities and equity. It is useful to see the percentages on the trend line, which shows the relative changes in the accounts.
• Comparative: Using this format allows you to compare the three sections at various times.
• Vertical: In this format, all items related to the three main sections of a balance sheet are listed in one column and the items are listed in decreasing order of liquidity.

Balance sheets help companies calculate "debt/equity" ratios that indicate the feasibility of a company paying its debts with equity.

Another key financial ratio is the "current" ratio, which is the number of current assets divided by current liabilities. This determines whether a company has the ability to pay its debts within 12 months.

## What does a balance include?

Each company's balance sheet looks different due to its unique financial situation and the business operations it conducts. Here are three items that typically appear on a balance sheet:

### Active

A company's assets are everything they own. It also refers to unused or unexpired prepaid expenses and costs with a future value.

Some assets may be cash, inventory, land, equipment, accounts receivable, and both temporary and long-term investments. There are two types of assets here:

• Current assets: These are usually short-term assets, such as cash or inventories that last less than a year.
• Long-term assets: This can include long-term investments, property, equipment, and other assets that do not convert to cash or are used up in a year.

### Passives

Limited and unlimited liabilities are the financial debts of a business. They can be current or non-current and are essentially what they owe to another party.

Some liabilities are loans, bonds payable, accrued expenses, accounts payable, and earned and unearned premiums. Here are two types of liabilities:

• Current liabilities: These are the debts that a company pays within a year. They can include wages, short-term loans, and accounts payable.
• Long-term obligations: Long-term liabilities are debts that last a long time. Some examples are deferred income tax and capital lease obligations.

### Shareholders' capital

Also known as owners or shareholder's equity, shareholders' equity is the net worth of the company or what is left over after paying off its debts. It is the difference between total assets and total liabilities.

The amount of assets listed on a balance sheet must be equal to the total of liabilities and equity on the balance sheet. This gives us the following formula:

Assets = liabilities + own funds

A balance sheet lists them in order of liquidity—the order in which they are easiest to convert to cash. It also starts by listing the liabilities that need to be settled sooner.

## How to create balances

Here are the key steps to creating any kind of balance sheet:

3. Consider the assets.
4. List the responsibilities.
5. Determine fairness.

### 1. Gather your financial records

Make sure you have all the necessary documents to fill out the balance. Gather all the transactions, invoices and financial statements related to the time period.

You can find this information in your company's general ledger, which shows all financial transactions recorded during a specific period.

### 2. Set balance

Determine the period of time you need the balance to cover. Most balances cover a financial quarter, but you can choose any time period you need.

Balance sheets equation have three sections: assets (equity), liabilities (debts), and equity (shareholder contributions and company profits). The basic accounting equation to prepare a balance sheet is:

Assets = Liabilities + Owner's Equity

The total sum of assets must be equal to the sum of liabilities and net worth. If it doesn't add up, there is probably an error in one of the period entries.

### 3. Consider assets

It devotes five lines to accounting for assets, which have a dollar value. These include amounts related to current assets (things that owners can convert to cash within a year) and long-term assets (things that cannot be converted to cash within a year).

When listing assets, rank them according to their liquidity. This represents how quickly assets can be converted into cash. Here is a guide to adding assets to each line:

• Line 1: Enter the amount of cash available to the company.
• Line 2: Enter accounts receivable, or the current amount your customers owe your business if you give credit.
• Line 3: Enter the value of your company's current inventory.
• Line 4: List fixed assets, such as equipment, vehicles, land, buildings, and other high-value assets owned by your business that depreciate over time.
• Line 5: Add the total assets on this line. This is the sum of lines 1–4.

### 4. List responsibilities

A company's liability typically has four lines. It is helpful to list liabilities by maturity date, and then determine whether they are current or long-term. Here's how to list the liabilities:

• Line 6: If your business has any credit card debt, enter it here.
• Line 7: Long-term bank loans or other loans of more than one year belong to this line.
• Line 8: Your business accounts payable refers to short-term debts, such as amounts owed to vendors for items purchased on credit.
• Line 9: The last line of this section shows the total amount the business owes, including the owner's investment in the business. This total must equal the total assets because the business must not own more than it owes.

### 5. Determine fairness

The last section of a balance sheet is known as the equity or owners' equity category, which lists the money currently owned by the business on about four lines.

It refers to the amount that belongs to the owners of the company, among others:

• Line 10: Enter the amount of owners' equity invested in the business. This represents all investments contributed to the company.
• Line 11: Include here any number of private or public shares.
• Line 12: List here the retained earnings of your business or the amount of income less expenses since the start of the business.
• Line 13: This line shows the total equity of the company.

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