Balance Sheet Equation Explained

It is a well-accepted fact that the balance sheet of any business tells us about its financial strength. Investors always study the balance sheet before making any decision about investments in that particular company.

The contents of a balance sheet are standard and internationally accepted and companies have to present it to the outside agencies as a financial statement. Let us know more about some of the fundamental ideas associated with balance sheets.

The balance sheet of any company will give you details about its assets, liabilities, and total shareholder's equity. The assets can be of two types - current and fixed assets. The assets held by the company, such as cash and cash equivalents, inventory, accounts receivable etc. are included in the current assets column.

The fixed assets of the company would be the plant and machinery which it owns, land, properties, along with intangible assets. The sum of the current and fixed assets will give you the total assets held by the company.

The assets which get ultimately converted into cash within a period of one year are known a current assets in the balance sheet. On the other hand, fixed assets have a life of more than a year. Assets are subject to depreciation and it is subtracted from their value by following the basic accounting principles.

Then, the next column in the balance sheet is that of liabilities. These are the obligations of the company to other companies, banks or institutions which need to be acted upon, as soon as possible.

Lesser the burden of liabilities, more self-sufficient and prosperous the firm will be. The liabilities side mainly consists of accounts payable, taxes to be paid, and the long-term bonds issued by the firm.

Bonds are the loans granted by investors to corporations and hence they are included in the liabilities side of the balance sheet of the company.

Whenever an individual purchases a bond, he has advanced the money to the company for its expansion policies and he is supposed to be paid fixed returns per year by the company. The sum of all these individual liabilities will give you the total liabilities.

From the above explanation, we know how to find out the total assets and liabilities of any firm. The balance sheet equation makes use of the assets, liabilities and the shareholder's equity and helps us to deduce any one of them easily, if the other two are known.

Assets = Liabilities + Shareholders' Equity

Thus, if you wish to calculate the shareholders' equity in a company, you will have to subtract liabilities of the company from its assets held in a specific period of time. You must remember that the shareholders' equity consists of common stock, as well as retained earnings of the company.

Retained earnings are those earnings or profits which are preserved by the company for a long time. These earnings will remain in the balance sheet of the company and are not given out to shareholders in the form of dividends. This money can be utilized by the company for its aggressive expansion policies to achieve steady and fast growth.