The purpose of a balance sheet is to show the financial position of a business on a certain date, usually the end of the month or year. For this reason, it often is called the statement of financial position and is dated as of a specific date. The balance sheet presents a view of the business as the holder of resources, or assets, that are equal to the claims against those assets. The claims consist of the company’s liabilities and the owner’s equity in the company.
This chapter focuses solely on the balance sheet, which is often called the statement of financial position. Beginning with formal definitions of the basic elements of the balance sheet, the discussion describes the types of assets, liabilities, and owners’ equity that are found on the balance sheets of most business firms. A variety of balance sheet ratios are presented to show how managers and investors use balance sheet information in making decisions.
The basic elements of the balance sheet are assets, liabilities, and owners’ equity. Liabilities and owners’ equity are the sources from which a firm has obtained its funds, and assets show the way that the firm’s managers have invested those funds as the balance sheet shows a firm’s assets, liabilities, and owners’ equity. Assets are valuable resources that a firm owns or controls. The simplified balance sheet shown in the following figure includes four assets. Cash obviously has value. Accounts receivable are amounts owed to Harrisson Company by its customers; these have value because they represent future cash inflows. Inventory is merchandise acquired that is to be sold to customers. Newton expects its inventory to be converted into accounts receivable and ultimately into cash. Finally, equipment (perhaps delivery vehicles or showroom furniture) enables Newton to operate its business.
Liabilities are obligations of the business to convey something of value in the future. Harrisson’s balance sheet shows two liabilities. Accounts payable are unwritten promises that arise in the ordinary course of business. An example of this would be Newton purchasing inventory on credit, promising to make payment within a short period of time. Notes payable are more formal, written obligations. Notes payable often arise from borrowing money.
The final item on the balance sheet is owners’ equity, which refers to the owners’ interest in the business. It is a residual amount that equals assets minus liabilities. The owners have a positive financial interest in the business only if the firm’s assets exceed its obligations.
At the end of this chapter, You will know to:
- Identify the basic elements of the balance sheet.
- Recognize the types of assets, liabilities, and owners’ equity that are found on the balance sheets of most business firms.
- Comprehend the ordering and classification of items on the balance sheet.
- Appreciate why balance sheets differ for firms in different industries.
- Use balance sheet relationships to obtain information useful to investors and lenders.
- Be alert to the limitations as well as the usefulness of balance sheet information.
Balance Sheet Contents
- Elements of the Balance Sheet