If a stranger asked you to invest in his business, the first question you should ask yourself is this: how do I know that I will get my money back? To answer this question, you would want to know the type of business this individual runs, what equipment his company owns in order to make his product or deliver his service, the amount of money he has borrowed from other people, and the amount of money from his own bank account he has already invested in the business.
The answer to all these questions will give you a more comfortable feeling about parting with your hard-earned money. A balance sheet will give you some of the answers to these questions.
WHAT IS A BALANCE SHEET
A balance sheet is a snapshot of what a company owns (or assets), what it owes (or liabilities), and the amount of money the owners have invested in the company (or shareholder's equity or owner's equity or just plain equity). One thing that is always true about balance sheets is that assets are equal to the sum of liabilities and shareholder's equity. In other words, the formula below must always hold true:
Assets = Liabilities (borrowings) + Equity (contributions)
This always holds true because what a company owns (its assets) are purchased by the money the company either borrowed (liabilities) or has acquired through the contributions of the partners (shareholder's equity).
The balance sheet is produced based on an idea developed more than 500 years ago called "double-entry accounting" by an Italian mathematician named Luca Pacioli. Double-entry accounting provides an easy way for businesses to keep track of their assets, liabilities, and shareholder's equity.
This method of keeping track of a company's activity is called double-entry accounting because at least two types of accounts (categories of assets, liabilities, and equity) are always affected. For example, if a company buys a new car, one type of asset (equipment) goes up, while another type of asset (cash) goes down. Things can get more complicated than this but we hope you understand the basic idea.
Balance sheets have dates attached to them because assets, liabilities and shareholder's equity can change every day. So when you see a balance sheet, you will probably also see the date it was created on the top of the table.
THE TYPICAL CORPORATE BALANCE SHEET
In all balance sheets, you will find the asset, liability and shareholder's equity categories. However, when you start to look at balance sheets for companies in different businesses, you will see big differences in the details of what makes up assets and liabilities. For example, the assets of a car manufacturer like Ford Motor Company will include the big equipment the company uses to make cars. (See the balance sheet of Ford at the end of this page).
But how about a company whose assets is its business know-how? For example, an accounting firm like KPMG, which provides accounting services to big corporations, will have smaller fixed assets than Ford. This is understandable because KPMG does not really manufacture anything. The company simply provides services through its employees--whether it is creating balance sheets for companies or telling companies how to run their businesses better
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