Finding Balance

We enter into a new era of They’re Counting On You, and that is the era of Finance. We start this journey with one of the three essential financial statements: the balance sheet.

1. What is a balance sheet?

I’ve heard the following analogy a couple of times and I think it does a pretty decent job answering this question. A balance sheet is like a formula for calculating a company’s net worth.

Imagine if you were to calculate your own net worth. What would that equation look like?

You might start with everything you own. The finance world calls these assets.

Assets

Assets come in may forms. To use the net worth analogy, an easy example is to think about places you’ve stored money. Some examples:

• Retirement accounts: 401k, IRA

• Brokerage accounts

• Health Savings Accounts (HSAs)

• Flexible Spending Accounts (FSAs)

• Cash under your pillow

These examples are easy to sum up to calculate a number that could represent your net worth. But your job wouldn’t be done yet. You could still own things that could be converted into cash if you were to sell them.

For example:

• Your house or any property you have ownership in

• Your car

• A piece of artwork

• Wine

• Equipment

• Cryptocurrency

• Stock

• A business

All of the above are considered assets. Assets are essentially anything that can be converted to cash. And if you know anything about cash, you know that it’s king (more on this later).

Different Kinds of Assets

Not all assets can be converted to cash with ease. There’s a term the finance world uses to explain an asset’s ability to be converted to cash. That term is liquidity.

Assets are usually separated into two categories: current (liquid) assets and non-current (illiquid) assets. There’s actually a third category, intangible assets, but we’ll save those for another day.

We want to separate assets this way so we can answer: if we really needed cash, how long would it take for it to be available?

Why do we need to know this? Because cash, among many other things, allows us to pay our bills. Which is a nice segue to the next section of the balance sheet.

Liabilities

Let’s continue with the net worth analogy. You’ve added up all of the value you own in your assets. Now what?

Well if you are amongst the 43 million Americans who carry student loan debt, then you have a liability.

If assets are what you own, then liabilities are what you owe. What are some examples?

• Car loan

• Home loan

• Credit card debt

• Studen loan debt

• Medical bills

• Alimony 😬 

• Pending lawsuits 😬 😬 😬 

Liabilities are separated into two categories similarly to assets: Current liabiliites (need to be paid off near-term) and non-current liabilities (e.g. a mortgage).

The finance world separates liabilities out this way so that they can more easily determine what their working with. In fact, working capital is the amount of money left over when you subtract current liabilities from current assets.

But we’ll leave that for another day. For now, let’s finish calculating your net worth.

Equity

Your net worth can be calculated with a very simple equation:

Net Worth = Total Assets - Total Liabilities

For a business the equation is the same. Except what you might call net worth, the business will call equity.

Equity = Total Assets - Total Liabilities

…or another way of putting it:

Total Assets = Total Liabilities + Equity

Your net worth is what you own after you’ve accounted for everything you owe. Equity is what the owners of a business (investors and shareholders) own after all of the business liabilities are accounted for.

Putting It All Together

The equations above are the equations of the balance sheet. Balance sheets are one of the core financial statements that illustrate the health of a business.

The balance sheet is essentially a list of everything the business owns and owes as of a specific point in time (the reporting date). Businesses use this list, along with the equations above, to determine the “net worth” of the business (a.k.a. equity).

It is called a balance sheet because both sides of the equation must always balance. If they do not, then there is either an error in the data or there may be bias.

For many businesses, it is not so straightforward to get simple numbers for financial statements. For this reason, accountants and finance teams have to make assumptions, and these assumptions carry their own biases.

2. Why data needs to know about balance sheets

Imagine you walk into a room with a bunch of colleagues. They’re all talking about the latest episode of a popular TV show.

You have never watched this show and have no idea what they’re talking about. You have nothing to contribute to the conversation.

This is how it feels when you’re in a room of people using financial language. It’s as if they’re talking about a TV show you’ve never seen.

Understanding balance sheets, and all of the financial statements, is like watching the first episode. The business is counting on you to learn this language so that you will be able to contribute to the conversation.

3. What the balance sheet tells us

When we are young, our net worth is low. It might even be negative.

But over time, we should hope to see our net worth grow. Similarly, business owners and investors want to see their equity grow.

This serves as another reminder that a business is an investment vehicle. ROI is the primary incentive for most people starting or investing in a business.

One weakness of the balance sheet is that it only reports this information as of a specific day in time. This is why it’s best to compare balance sheets over time to make sure the business is moving in the right direction.

It’s also worth combining the balance sheet with the other financial statements for a more complete understanding of the business. We’ll be diving into these in the coming weeks.