In more technical terms, the balance sheet is a financial snapshot of a company’s assets and claims on those assets at a specific point in time (the end of the fiscal period).
Assets = Liabilities + Stockholders’ Equity
Think of assets as everything the company owns, and liabilities and equity as all the money that paid for those things. For example, imagine you buy a cell phone for $400. In order to pay for it, you borrowed $150 from you parents and provided $250 of your own money. So, in accounting lingo, your cell phone is recorded as your asset of $400, your liability is $150 (the money you owe to your parents), and your equity is $250 (the money you provided).
A formal definition of assets would be something along the lines of this:
“Assets are items owned by a corporation that have economic value and can / will be converted into cash in the future.”
To make this a little bit simpler, think about your life a little bit and the things you own. Your house, car, furniture, cell phone, clothes, TV, books, sports equipment, cash in your wallet, etc. All these things can be referred to as your assets. They all have some value for which you could sell them.
Now think about it from a company’s perspective. They own cash, buildings, equipment, land, and many other things. It should be fairly obvious that all companies differ in their assets since they don’t own the same things and same amounts of them. However, there are some general names for assets that most companies own.
Two common ways of categorizing assets are to split them into current and non-current, and tangible and intangible.
Current assets are those that are usually converted into cash within one year, while non-current assets are those that are not expected to be turned into cash within one year.
Tangible assets have physical property. In other words, you can see them or touch them. Things like property, plant, equipment, and land fall in the category of tangible assets. Intangible assets are non-physical ones – the ones that are much harder to value. Examples of intangible assets are patents, trademarks, and goodwill.
- Short Term Investments
- Accounts Receivable
- Prepaid Expenses
- Property, Plant, and Equipment
- Long Term Investments
Cash is cash. It’s money that the company has available right away. Sometimes this category is also called Cash and Cash Equivalents and it includes checks, and other things that can be easily converted to cash.
Whenever you pay a bill with a credit card, you are paying for the item but you don’t provide the actual cash. So when companies get payments on credit, they record them in accounts receivable. When they get the actual cash, they then decrease accounts receivable by that amount and transfer it to cash.
All the cereal that Kellogg holds in storage and didn’t sell yet is Kellogg’s inventory. All the cars that GM didn’t sell are GM’s inventory. Different companies have different kinds of inventory, depending on what business they’re in.
A manufacturing company will have three different kinds of inventory:
- Raw materials – These are things that are used to make the company’s product. So for a wooden toy, you need wood. But if wood is not processed, it is still only a raw material.
- Work in process – All the things that are started but not done are called work in process. So, this would be this wooden toy that is only halfway complete.
- Finished goods – These are goods that are finished. Done. Ready for sale.
On the other hand, a retailer (i.e. Target) will only have “regular” inventory because all of the goods they currently hold are finished goods – ready for sale.
Prepaid expenses are future expenses that you paid for in advance.
For example, imagine your monthly office rent is $10,000, and you decide to pay for a full year of rent in advance, a total expense of $120,000. At the moment of transaction, the Prepaid Expense account of $120,000 would show up on your balance sheet. As you start using up the rent, each month your Prepaid Expense account would decrease by $10,000 (the amount of rent you used). Therefore, after three months in your office, your Prepaid Expense balance would decrease to $90,000.
Short-term investments are usually investments in all sorts of securities that will be transferred to cash within a year.
If short-term investments are investments that will generate cash within a year, then long-term investments are the other ones – those that last for more than a year.
Property, Plant, & Equipment
This is a category where companies lump together a lot of different things, just like the name says. This is where all the land, buildings and machines get accounted for.
This one is a popular intangible asset that arises when a company buys another company. Let’s say Toyota wants to buy Tesla Motors. Say Tesla Motors’ fair market value is estimated at $2.5 billion. Now, if Toyota wants to buy Tesla Motors, they will probably have to pay a premium price to get them to sell. So, let’s say Toyota pays $2.7 billion for the company. This difference of $0.2 billion is called goodwill.
It’s called goodwill because no one really knows why the $0.2 billion in excess of company’s fair market value was paid. People argue it’s because this company will have even more value for Toyota because of certain synergies, but there’s no actual proof for that.
In the footnotes of reports you can read what these other assets are composed of for the specific company. In general, this is where companies lump together all the other miscellaneous stuff that can’t go into the more important and specific categories.
Liabilities represent a part of the financing portion for your company’s assets. All the things you own had to be paid with some kind of money. If you have a car or a house, there’s a great chance you borrowed money to pay for them.
Liabilities represent the money you borrowed as well as undelivered services/products. In short, liabilities are all the money you used to finance your assets that is not coming out of your pocket. Just like assets, they split into current and long-term liabilities.
Current liabilities are expected to be paid off within one year, while long-term liabilities will be paid off over one year from now.
- Accounts Payable
- Accrued Expenses
- Short Term Debt
- Deferred Revenue
- Long Term Debt
Accounts payable are much like accounts receivable on the asset side, but in this case it is the company that is buying something on credit. Therefore, whenever a company buys inventory on credit (doesn’t pay with cash), it increases its accounts payable. This means that this amount will have to be paid in the near future.
Deferred revenue refers to the amount of revenue related to products/services you sold but still need to earn. This might not make sense right away, but accounting standards have certain rules for recognizing revenues, meaning you can only account for revenue of a sale when certain criteria are met.
Still confused? Here’s an example: if you sell the subscription on a magazine for 12 months for $600, you will collect full $600 in advance, but you can’t account for it as revenue yet because you haven’t delivered the product (magazine) to the customer yet. So, you will increase your Cash account by $600, and also your Deferred Revenue account by $600.
As you deliver your first month of magazines ($50 worth), you will decrease your Deferred Revenue account by $50 (to $550), and recognize Revenue of $50.
Debt is straightforward. You borrow money and agree to pay it back in the future. Short term debt refers to all borrowings that are due within one year from the date the balance sheet was reported.
Much like short-term debt, long-term debt is borrowed money that has to be repaid in the future. The only difference is the timing. Long-term debt has to be repaid sometime over a year from the date on the balance sheet.
If liabilities represent one portion of your company’s financing for assets, equity represents the other portion. It represents the ownership part of the company. This is also called Shareholder’s Equity.
Again, remember all of the things you own. All the money that was paid out of your pocket (Cash) represents the equity.
From the company’s perspective, equity is buying a participation in a company and agreement to share its profits. It is the riskiest type of investment, but also the one with the greatest upside.
The equity section on the balance sheet is usually split into two main parts – contributed capital and retained earnings.
Contributed capital summarizes the total value of stock that shareholders have purchased directly from the company. It usually consists of common stock that is split into par value and additional paid in capital.
Par value refers to value that company priced their stock at the time of issuance, while additional paid in capital is the excess value that investors paid for that stock. For example, the company prices their common stock at $1. However, because of the high demand in the market, they sell it for $15. In this case, if an investor purchased one share of the stock, par value would increase by $1, and additional paid in capital would increase by $14.
Common stock represents the equity ownership in a corporation, and it entitles holders to voting rights. Shareholders can benefit either through dividend payments or stock price appreciation.
Retained earnings are all the profits kept in the company after it has paid out all dividends (if any). It is calculated through the following equation: