1. Introduction to the balance sheet
In the second chapter of this course, we will be looking at the balance sheet, which is another important part of financial management and forecasting. We will explore specific tools and metrics the balance sheet can show us about a company and how to use this for forecasting. So let's dive a bit into some theory before starting the exercises.
2. Types of financial statements
For a quick refresher, we previously saw there are four types of financial statements. For this course, we are focusing on the first two. As we saw in the previous chapter, the income statement looks specifically at income and expenses.
Now, we will focus on the balance sheet, which looks at assets, liabilities, and capital, also known as equity. But what does this mean exactly? Let's have a look.
3. Assets and liabilities
An asset in financial terms, is an economic resource, one that can be used to make money. For example, a house is an asset. You could rent it or sell it to make money. But what about a liability?
A liability, to follow on our example, would be the mortgage you have taken to buy the house. In financial terms, a liability is an obligation, usually the obligation to pay for something.
4. Equity
So what is the third part of the balance sheet? This part is called equity. Equity is calculated as assets minus liabilities and also known as the Owners interest or capital in a business.
What does this mean? Well, let us look at the house example again. If a house is an asset, and it costs 100,000 USD, we would be able to put down 20,000 USD of our own money, that would be equity, and finance the rest with a mortgage.
As you pay off the mortgage, your equity should increase, if the value of your house remains constant. Of course, the worse scenario is when the value of the house decreases and if you have a mortgage higher than the value of your house, perhaps you understand now the term "negative equity"!
So now you can understand this example, the balance sheet of a company is exactly the same, and is made up of owners equity, assets, and liabilities. The owners' equity is always the balance between assets and liabilities.
5. Example
Remember Mark's gadget shop from the previous lesson? Well, the different financial statements are very interlinked. The balance sheet and income statement show different parts of the whole.
Let's have a look at what Mark's gadget shop balance sheet and income statement would look like.
6. Example
We had a look at our sales in the previous lesson, but what happens when we sell on credit to our customers? Well, we still record the sales in our income statement; however, we record the sales on credit under the accounts receivable, or debtors item, on the balance sheet.
7. Example
If we sell on credit, we can buy on credit as well. There could be items both under the gross profit and net profit where we set up a liability to pay at a later date. We record this under accounts payable, also known as creditors.
8. Example
There are other items in the balance sheet as well, including assets, such as cash in the bank, as you can see here, but also inventory, or other income-generating assets, and other liabilities, such as loans.
We will focus on getting a good understanding of the most important assets and liabilities in this lesson and how we can use the information in the balance sheet to build financial forecasts.
9. Let's practice!
So enough theory - time to put this into practice.