As mentioned earlier, the balance sheet represents the financial position of a company at a specific point in time. While it reflects the accumulation of the company’s past activities, a careful analysis of the balance sheet can also provide insights into the company’s future.
The balance sheet typically displays assets on the left side and liabilities and equity on the right side. One fundamental characteristic of the balance sheet is that the totals on both sides must always balance. Looking at the right side, liabilities and equity essentially show how the company has financed its activities. This indicates whether the funds were raised through debt (liabilities)—money borrowed from banks or creditors—or through equity (capital)—money received from shareholders in exchange for ownership, or profits earned through operations. Therefore, when we later connect the cash flow statement with the balance sheet, the items under liabilities and equity will be most closely related to the cash flows from financing activities (CFF) on the cash flow statement.
The left side of the balance sheet, which lists assets, is broadly divided into current assets and non-current assets. While we will delve deeper into their differences later, the basic distinction lies in liquidity. Assets that are close to cash or can be quickly converted into cash are classified as current assets. Typically, the dividing line is one year—assets that are expected to be converted into cash within a year are recorded as current assets, while those that cannot are classified as non-current assets.
The balance sheet represents the sources of assets on the right side as liabilities and equity. Whether it’s cash, inventory, or tangible assets like factories, they are shown as being funded by something on the right side. As we learned in the first session, a company’s three main activities are operations, investing, and financing. Typically, companies engage in financing activities to fund their operations or investments. Therefore, asset accounts on the balance sheet are often closely linked to the operating and investing sections of the cash flow statement. Current assets are generally associated with operating activities, while non-current assets are typically linked to investing activities.
Just as asset accounts are divided into current and non-current, liability accounts are also typically categorized and reported in the same way. The dividing line is also one year: liabilities that are due within one year are recorded as current liabilities, while those that are not due within a year are classified as non-current liabilities.
Another way to view liabilities, which is even more important for corporate analysis, is by dividing them into operating liabilities and financial liabilities. Liability accounts include financial liabilities, such as loans borrowed from banks or bonds issued by the company, as well as operating liabilities, such as accounts payable and advance payments, which we will learn about later. Financial liabilities are particularly significant because they incur interest expenses and represent actual funds raised from external investors. This makes them a critical aspect of analyzing a company’s financial health.
Capital accounts can also be further classified in more detail. Capital can be divided into paid-in capital and retained earnings. Paid-in capital refers to the money that shareholders have invested in exchange for ownership shares of the company. For example, in the case of the steakhouse business we discussed earlier, the $100K I invested would be considered paid-in capital. On the other hand, retained earnings is where the money earned by the company through operations accumulates. When the company generates revenue, subtracts all its expenses, and ends up with a net profit, that net profit belongs to the shareholders. Therefore, the net income amount is recorded under the equity section on the balance sheet and, more specifically, under retained earnings.
When analyzing the balance sheet, understanding the detailed accounts is important, but it is even more critical to first analyze and understand the broader categories. By dividing assets into current and non-current assets, liabilities into current and non-current liabilities, and equity into paid-in capital and retained earnings, you can make corporate analysis much more straightforward.
In summary, companies typically raise funds through financial liabilities or paid-in capital. These funds are primarily used for investments in non-current assets, which the company then utilizes to conduct its operating activities.
As a result of operations, current asset items such as inventory and accounts receivable are created on the asset side, while operating liability items such as accounts payable and advance payments appear on the liability side. Most importantly, if the company generates net profit, this results in an increase in cash on the asset side and an increase in retained earnings on the equity side. The company can then use this to invest further in non-current assets or to repay liabilities.
Ultimately, the balance sheet will resemble the final illustration. You can see that the company as a whole has grown compared to the initial diagram, right? In this way, if the company performs well operationally, its balance sheet will continue to expand. Both assets and the scale of liabilities and equity will grow. The balance sheet we typically observe is the one that reflects all the outcomes of the company's operations over a specific period, as depicted in the third and final diagram. It captures the company’s financial state at the end of a given period, at the very last moment.
