Balance Sheet Equation

This article is a note that I wrote for myself while taking the course Introduction to Financial Accounting which is available in coursera.

The balance sheet is prepared at the close of business on the last day of income statement period. The balance sheet has two main components, assets and liabilities. Assets are registered on the left side of the balance sheet and liabilities are registered on the right side of the balance sheet. Assets and liabilities should balance out each other.

Assets = Liabilities

Assets: Assets are something has economic value or the items that can help a business to generate future cash flow. Cash, account receivables, prepaid rent, plants, equipments and software are some items that are classified as assets in the balance sheet.

Liabilities: Liabilities are claims on the business. Loans, notes payable, share holder equity are some items that are classified as liabilities in the balance sheet.

Assets include both Cash and Non-Cash components. In the same way liabilities has general liabilities (that business owes to other parties), contributed capital, retained earnings.

Assets      = Cash + Non-Cash Assets
Liabilities = Liabilities + Contributed Capital + Retained Earnings

Contributed capital is the total value of stock that shareholders of the business have directly purchased from the issuing company. Let’s say a company sells 1000 units of common stocks in an IPO at the par value of $10 per share. Let’s say the market values each stock at $100 per share during IPO. Now, the business will get $100,000 from market which it can use to pay its obligations or use it to invest and grow the business. Out of $100,000 received from market, $10,000 would be classified as share capital and $90,000 would be classified as paid-in-capital.

Contributed Capital = Share Capital + Paid-in-Capital

Over the year, any good business would generate income which would be classified as income.

Net Income (or Earnings) = Revenue - Expense

There are only few things a company can do with the profit it generates from the business. The company can re-invest the profit to grow its business and generate higher future return, return the profit by paying dividends or can re-purchase its own stock by declaring a stock buy-back.

What is retained earnings? Retained earnings is the net earnings retained by the company after paying dividends.

Retained Earnings = Previous year's Retained Earnings 
                    + Net Income 
                    - Dividends

In other words, if the business earns a net income of $100 in its first year after IPO, the retained earnings will be $100 provided if the company did not pay any dividends.

Balance Sheet Equation:
Cash + Non-Cash Assets = Liabilities 
                         + Contributed Capital
                         + Prior Retained Earrings 
                         + Revenues 
                         - Expenses 
                         - Dividends

In order to sustain in business, a business must generate revenues more than the expenses. As revenues contribute to increase in share holder equity and expenses contribute to decreases in share holder equity, a high net income is required so that the share holder equity can go up, which in-turn would creates value to the companies share holders. We have to also keep in mind that any company would need invest to grow its business over the long run.  With higher net income, the company wouldn’t need to dilute its share to raise capital from market, it can simply re-invest the income that it recently generated for its business.

This reminds me of a quote I read recently, which is, “In great business, customer pays first”. Generally the company had to invest capital, create products or services, sell it to their customers and collect payments. In a great business, the customer pays first before they consume the goods or services. This is great because this company can now grow using customers money instead of raising capital from the market, thus creating wealth to its existing share holder in the long run.

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