Analyzing the Financial Statements: The Balance Sheet
September 2, 2007
You should know what a balance sheet is and what it isn’t. Every balance sheet ever prepared for any business is perfectly balanced! This is not the result of accountants being mathematical wizards. Rather, it’s because a balance sheet represents an equation, and the left side of an equation always equals the right side.
The equation is:
Assets = liabilities + net worth
Stated differently:
Assets - liabilities = net worth
Not only is every balance sheet an equation, it’s an equation as of a given moment in time. Let’s take a look at the balance sheet in Table 4.1. It reveals the following:
Assets ($822,658) = liabilities ($131,243) + net worth ($691,415)
What this means is that if we’d gone into Houston Sash & Door and taken a snapshot of all of its assets and liabilities at 11:59 P.M. on December 31, 2003, we’d have come up with $822,658 in assets and $131,243 in liabilities. The difference would have been what was left over ($691,415) for the owners. Because of this, net worth is frequently termed shareholders’ equity. Had we taken our snapshot on December 30, 2003, or January 30, 2004, the assets, liabilities, and net worth might have been somewhat different, but the results of that snapshot would also have balanced.
How did we arrive at all the numbers for each of the entries (in accountant’s lingo, the “accounts”) on the balance sheet? By and large, balance sheets tell us only about the cost of assets when they were bought, not what they’re worth now! Balance sheets tell us how much we were obligated to pay on the date of the balance sheet, not how much we think we’re obligated to pay now. In other words, balance sheets tells us what things cost in the past, hence the terms book accounting and historical accounting. Does a balance sheet ever tell us the real net worth of a business? Never!
Take the equipment, furniture, and fixtures account on Houston Sash & Door’s balance sheet. It tells us Houston paid $60,868 as of December 31, 2003, for this group of assets. How much are they worth today? If you were to sell them today, would you get $60,868, $6,868, or $600,868? There’s no way of knowing. A balance sheet isn’t supposed to tell you that. With this in mind, let’s take a look at each account on the balance sheet, paying particular attention to its relevance to the purchase of a business.
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