The balance sheet is a financial statement which provides an overall picture of your business at any given point in time. The term balance here refers to a business’ assets, liabilities, and equity being in balance; these aspects are explained below.
The balance sheet is presented as a simple equation:
assets = liabilities + equity
Assets are items your business owns or holds, which are used to fund the business and generate sales. Examples of assets are the cash in your business bank account, office equipment, the inventory needed to create the products you sell, the machine used to turn your inventory into products, and the vehicle used to deliver these products. There are many types of assets that a business can hold, but how do businesses create or increase their assets?
Assets are easiest to think of as cash. How do you pay for business expenses? Cash. How do you pay your employees? Cash. How do you pay for inventory? Cash. How do you pay yourself? Cash. How does the business pay back bank loans? Cash. A business needs cash, or assets, to survive.
Business assets are generated from multiple means. They can be borrowed from a bank, borrowed from owners, generated from other assets (like cash used to buy inventory or a vehicle), or they can be generated from your business selling a product or service (sales revenue).
A liability represents an obligation of the business. This is commonly a loan from a bank or the promise to pay back a vendor in the future. A business would request a loan from a bank when they need cash or assets to start or expand their operations. From this loan, assets are received and a liability is created. With a vendor, inventory is received and a liability is created. Once the bank loan or the vendor payment is due, business assets are used to settle these debts.
Equity, also referred to as stockholders’ equity or owners’ equity, is the owner’s interest in the business. It is your assets minus your liabilities. If you contribute assets (cash or otherwise) into the business, equity is created. If you take assets out of a business, equity is reduced.
Equity also represents the lifetime earnings of a business, minus any lifetime losses. This is referred to as retained earnings. These earnings can be withdrawn from the business by the owners’ as a return of their initial investments into the business. Going back to the balance sheet equation, assets = liabilities + equity must always balance. If assets go up, either liabilities and/or equity must increase by the same amount. The balance sheet is the basis of this financial statement, and presents where the business stands at a point in time.