In the October 2002 NumberSMART Newsletter© we looked at the Income Statement…the alpha and omega of business. This month we'll take a look at the much maligned and misunderstood sibling of the Income Statement…the Balance Sheet. Also known as the Statement of Financial Position, this financial statement shows the Assets, Liabilities and Equity of an organization at a specific point in time. It's a snapshot of the financial strength of an organization and will help you answer the following questions:

Is the organization carrying too much debt?

Is the organization generating enough working capital to finance operations?

Is the organization's asset base growing or shrinking?

Is the organization financing expansion by borrowing money or selling stock?

Are retained earnings growing as fast as profits?

Is the organization generating enough cash flow to meet bank loan and dividend payments?

The Balance Sheet represents a mathematical formula, known as the Fundamental Accounting Equation, that is expressed as follows:

Assets = Liabilities + Equity

The terms Assets, Liabilities, and Equity are familiar to most of us on a personal level. For example, if you paid $200,000 for your house (an Asset), and your mortgage was $150,000 (a Liability), your equity in your house would be $50,000. You would own a 25% stake ($50,000 ÷ $200,000) in your house. As your mortgage is paid down, your equity would increase.

Similarly, the amount of Equity (Shareholders Equity) on the Balance Sheet of an organization, in relation to its Assets, will tell you what proportion of the Assets are owned by the shareholders. If the Shareholders Equity of an organization amounts to $60 million, and Total Assets amount to $100 million, the shareholders own, you guessed it, 60% ($60 million ÷ $100 million) of the assets. If we plug these numbers into the Fundamental Accounting Equation (a great cocktail party topic), we get:

$100 million = X + $60 million…

therefore, X must equal $40 million (the total amount of Liabilities) in order to balance the equation. That's why this financial report is called a "Balance" Sheet. The left-hand side, or Assets, must always equal the right-hand side, or Liabilities plus Equity. Note that as an organization pays off its Liabilities, its Shareholders Equity will rise. Shareholders Equity is also sometimes referred to as Net Assets (Assets minus Liabilities). Now that we understand how a Balance Sheet is structured, let's define some terms.

Assets represent anything of value that is owned and are categorized in the Balance Sheet as either Current (Cash, Accounts Receivable, Inventory, Prepaid Expenses) or Long-Term (Equipment, Building, Land). Current Assets, by definition, will be converted to cash, or consumed by the business, within one year of the Balance Sheet date. For example, we expect to convert our Accounts Receivable into cash within one year of the Balance Sheet date. And we expect to consume Inventory within one year of the Balance Sheet date by turning it into finished product.

Long-Term Assets, on the other hand, have an expected life beyond one year of the Balance Sheet date. Because buildings, equipment, and machinery, for example, will not be consumed within one year of the Balance Sheet date, they are depreciated, or written-off.

Liabilities represent anything of value that is owed and like Assets are categorized as either Current or Long-Term. Current Liabilities (Accounts Payable, Payroll Taxes, Income Taxes, Bank Loans) represent obligations that will be paid within one year of the Balance Sheet date. Long-Term Liabilities (Accrued Pension Liabilities, Long-Term Loans, Contingencies and Reserves), as the name implies, represent obligations that will be paid beyond one year of the Balance Sheet date.

Why do the Liabilities on a Balance Sheet get categorized as either Current or Long-Term? This is done to help bankers, creditors, and shareholders assess an organizations ability to meet its short-term (within a year) and long-term (beyond a year) obligations.

Shareholders Equity is comprised of Capital Stock and Retained Earnings. Capital Stock represents the value that an organization has received as it sold its stock over the life of the organization. Note that Capital Stock is shown at historical value and not at current market value (what the stock is trading at on the stock market today).

Retained Earnings represent the accumulated profit that has been retained by the organization after dividends have been paid to shareholders. Every month, the after-tax profit, or loss, is transferred from the Income Statement to the Retained Earnings account on the Balance Sheet. If an organization makes money, the Retained Earnings balance will increase. Conversely, if an organization loses money, the Retained Earnings balance will decrease. And if an organization is unlucky enough to lose money over a period of years, or even has one very bad year, the entire Retained Earnings balance could be wiped out. And nobody would be happy about that. Why?

The shareholders wouldn't be happy because they might not receive the regular dividend they have come to expect. Senior management wouldn't be happy because the shareholders, who determine their salary and grant stock options through the Board of Directors (at least in theory), wouldn't be happy. The stock market wouldn't be happy because the suspended dividend might trigger a drop in the share price. And finally, managers wouldn't be happy because they might have contributed to the whole mess (at least in the eyes of the shareholders). Everyone would be unhappy. All because of a six-letter word called PROFIT…or lack of it.