As Warren Buffett quoted “Account is the Language of Business .You have to understand accounting. Unless you put the effort to learn accounting – how to read and interpret financial statements – you shouldn’t select stocks yourself”.
The accounting balance sheet is one of the major financial statements used by accountants and business owners. (The other major financial statements are the income statement and statement of cash flows, and statement of stockholders’ equity).
In Part 1 of our series of articles, we will explain the components of the balance sheet.
The Balance Sheet
A financial statement summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders.
It’s called a balance sheet because the two sides balance out. This makes sense: a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders’ equity).
The balance sheet must follow the following formula:
Assets = Liabilities + Shareholders’ Equity
To illustrate simply how a balance sheet is formed, we are going to use an example of a new start-up of a Bakery Shop.
(A) You are starting a business with your own capital of $1000. To raise more money, you sell 500 shares at $1 each to an investor. Now the business is worth $1500(assets). In summary, you own two-third of the business and your business investor owns one-third of the business.
(B) You need more money to start up the company. You borrow $250 from the friend and you are going to pay 10% interest per year. This will be your liability.
(C) To start running your business, you need to invest buy or rent a place for your bakery. This will be your fixed asset and use your cash to obtain your fixed asset. In this example, you reduce your cash by $300 to rent or buy a place for your bakery and $200 to buy inventories such as flour, sugar, eggs, baking equipment etc. So, a snap shot of your company finance is summarized in the balance sheet as follows:-
In the next few articles we are going to learn to analyze a balance sheet’s components in depth.
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