The balance sheet shines a light on a company’s financial health. It provides a treasure trove of transactional details, all presented in a clear format. But why does a balance sheet need to balance, and what happens if it doesn’t add up? We’ll explore the finer points of the balance sheet equation below.
What is the purpose of a balance sheet?
Along with additional financial statements like the income statement and cash flow statement, the balance sheet is a fundamental component of your business accounts. It provides transparency in your accounting, showing a clear list of company assets and how they are funded. There should always be a clear balance between assets, liabilities, and equity.
The purpose of a balance sheet is not only to show your finances to investors, however. It’s also to ensure that financial transactions are accurately recorded. The balance sheet lists your debits and credits throughout the accounting period in question. When these items balance one another, it indicates that the information is correct. An imbalance indicates the need to go back and check your figures for errors.
How to read a balance sheet
When you first look at a balance sheet, you’ll see it’s split into two sections. The first section, usually written in the top half, shows the business’s assets. The second section or bottom half shows liabilities and equity. When figuring out how to read a balance sheet, it’s helpful to keep in mind that these two halves represent a different approach to business value.
Assets show how company value is actively being used.
Liabilities and equity show how company value was acquired.
Because assets are funded through a combination of liabilities and equity, the two halves should always be balanced.
Understanding the balance sheet equation
The balance sheet’s core is its central formula:
Assets = Liabilities + Shareholder’s Equity
The balance sheet equation provides a simple breakdown of the concept above. When you read a balance sheet, you’ll see a list of assets as well as a list of liabilities and equity.
For example, imagine that your business has $8,000 in cash sitting in its bank account. Cash is an asset, so this would be listed in the top half of the balance sheet.
To obtain this $8,000 in cash, your business took out a loan for $4,000 and earned $4,000 in profit. The $8,000 you have in cash equals the $4,000 loan plus the $4,000 profit. The balance sheet is indeed balanced, according to its central equation.
However, in real life, most company balance sheets will be far more complicated than this. Accountants use double-entry bookkeeping to keep everything in balance, ensuring that every transaction is recorded in at least two accounts. When you record a journal entry under assets, it must be balanced out with a second journal entry under liabilities or equity to show where the money’s coming from.
Reasons for an imbalance in the balance sheet
While it’s important for the balance sheet to always stay in balance, sometimes you’ll find that assets do not equal liabilities plus equity. What happens when the balance sheet equation doesn’t work? It means that something has gone wrong with your accounting. Typical errors include the following:
Forgetting to make a double entry for a transaction
Placing an entry in the wrong section
Inputting a positive number in place of a negative
Recording data from outdated or incorrect sources
Damages to accounting files
These could be due to human error or a software issue, but it needs to be corrected to restore balance.
While it’s still possible for the occasional accounting error to slip through, a balanced balance sheet offers a strong indication that all relevant debits and credits have been recorded accurately. This shows a full breakdown of your current business value, which is vital for investment and growth alike.
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