The Balance Sheet

Puzzled About DerivativesAnne wrote in and asked, “Can you to a tutorial on the balance sheet and the other financial statements. Is there a simple way to explain Financial Statements?”

Financial statements aren’t really that complicated in their basic forms. I’ll focus on explaining the balance sheet, with a little on Income Statements in this tutorial. I’ll explain how they are used step-by-step for an example caricature business.

Note: Each time I introduce a new item in the balance sheet I will place it in italics.

I cover all of this information in a video which I provide here The Financial Statement Video Tutorial

The Balance Sheet

The Balance Sheet provides you with a business’s financial situation at a specific moment in time.

The Balance Sheet

  • The left side of the Balance Sheet represents what a business has, or its Assets
  • The right side of the Balance Sheet represents how the business got the money to acquire those assets

All business’s are started with an Original Investment of Cash. The Cash a business owns is stored on the left side of the balance sheet. This is because Cash is an Asset. The Original Investment is stored on the right because it allowed us to acquire the cash asset.

The Balance Sheet Must Balance

The left and right side of the balance sheet must always equal or balance!

The Balance Sheet

Let’s say you need more than $100 to start your new business? One way to raise additional cash is to take out a loan. A loan that you are expected to pay interest on is known as Notes Payable. You can see in the balance sheet above where to place Notes Payable and how the loan effected your cash amount.

There are now 2 types of owners on the right side of the balance sheet. There are people the business owes money to and the part that the owners own (You). The part owned by the owners is called Owner’s Equity. The money you owe is known as a Liability.

If you understand:

  • The left side of the balance sheet documents your Assets
  • The right side documents Liabilities and Owner’s Equity
  • Both sides must always be equal

You now have learned the most important concept in regards to balance sheets!

Assets = Liabilities + Owner’s Equity

The Balance Sheet

We can now go in an label the balance sheet properly, by placing liabilities and owner’s equity where they should be.

The Balance Sheet & Your Business

Most business’s need something to sell. What you sell is referred to as Inventory on the balance sheet. When you buy Inventory your cash amount decreases, but the right side of the balance sheet remains unchanged.

The Balance Sheet Inventory

In this example suppose you’re starting a caricature drawing company. (Drawing cartoon versions of a person for money) To start this business you need quality paper and markers. Your inventory is made up of $35 for 50 sheets of paper and $15 for markers. This means it costs you $50 to make 50 caricatures.

Jargon Term: Unit Cost = The amount of money it costs you to make one item ie. 1 caricature

Jargon Term: Cost of Goods Sold (COGS) = The Unit Cost multiplied by the number of units you sell

Let’s say you go to a local dinner party and draw 40 caricatures for $2 a piece. That is a total of $80 in sales.

Jargon Term: Gross Profit = Number of units sold – the cost of goods sold.

Example

Cost of Goods Sold ($40)  = Unit Cost ($1) * Caricatures Sold (40)

Gross Profit ($40) = Sales ($80) – Cost of Goods Sold ($40)

The Balance Sheet and Earnings

We now have to update the balance sheet and add a new space for Earnings.

The Balance Sheet & Earnings

Above I have made changes to the balance sheet:

  • I increased my Cash amount by $80
  • I decreased my Inventory level by $40, because I sold it
  • I created a new entry Earnings Week to Date and placed my $40 profit there

It’s Time to Expand the Business

While at the dinner party you are told tou aren’t charging enough for your drawings. You’re also told you should rent a space at the local mall.

You look into it and discover you can rent a space for $80 per day. You decide to also invest in a sign for $20 and an easel for $30. You would normally create a new entry in your balance sheet for these fixed assets and depreciate them, but I’ll leave that for the next balance sheet article!

You spend $50 for more paper and markers and set out for the mall. You’ve increased the cost for your caricatures to $5 a piece to cover your new expenses.

Your first day at the mall is a success. You do 60 caricatures at $5 a piece for a total sales amount of $300! It is now time to subtract your cost of goods sold to find your gross profit.

Gross Profit ($240) = Sales ($300) – Cost of Goods Sold ($60)

You also have to include your new expenses on the balance sheet being the rent, sign and easel.

The Balance Sheet Expenses

You make the two sides equal by subtracting your expenses from your earnings.

Cash ($310) = Prev. Cash ($230) + Gross Profit ($240) – Expenses ($160)

You now know the basics of what goes into the balance sheet. You also have learned how to calculate Net Profit. Net profit is you profit after you subtract out the cost of goods sold and all other expenses.

Sales

– Cost of Goods Sold

Gross Profit

– Expenses

Net Profit

Time to Expand Again

You’ve decided to rent the location in the mall Friday thru Saturday this week. You also decide to sell caricatures of celebrities. So you spend $150 on paper and markers. You use that inventory to draw 25 celebrity caricatures. This leaves you with enough inventory to draw 125 caricatures over the 3 days at the mall.

These celebrity pictures are what we call a Finished Good on the balance sheet. Meaning it can be sold as is without any additional work needed. Let’s make our changes to the balance sheet.

The Balance Sheet & Finished Goods

I decreased my cash amount to both build my inventory and create the Finished Goods, being the celebrity pictures.

The Income Statement

The balance sheet is normally not updated everyday. The Income Statement, which is used to monitor sales, is normally updated every week however. We are going to use it here to monitor our sales through out the weekend.

Let’s assume we sold all of our 125 caricatures, but none of the celebrity pictures. This is what our weekend would look like on an Income Statement.

The Income Statement

You have seen a lot of this information before. The only thing that confuses people about income statements is that we only subtract the cost of the inventory that we sold and we ignore the inventory for what we didn’t sell! You’ve already seen how to calculate:

  • Cost of Goods Sold
  • Gross Profit
  • Net Profit

Finishing Up The Balance Sheet

Overall it was a pretty good weekend. with a net profit of $260 after paying all expenses ($240) and the cost of goods sold($125). Also as you are leaving a friend offers to buy all of your celebrity pictures for $3 a piece. That is a net profit after COGS of $50. He asks if he can pay you for the pictures next week, however and you say yes.

The mall operator also asks for 1/2 of next weekes rent in advance. You pay him $120 and run out of the mall before someone else asks for more money 🙂

Here is your final balance sheet for this article.

The Final Balance Sheet

There are some new entries in this balance sheet:

  • Accounts Receivable: Money owed to you because you sold the celebrity pictures on credit.
  • Prepaid Expense: Payments made in advance of receiving benefits. This is the $120 in rent you paid in advance.
  • Accounts Payable: Money owed by you to creditors. This differs from Notes Payable in that this is normally a short term loan that doesn’t require you to pay interest. You plan on asking for your next supply of paper and markers on credit, so you decided to put this on your balance sheet.

Because you created an Income Statement, it was easy to update your cash amount. Just add net profit to your previous cash amount. Since you are out of inventory just add Cash + Accounts Receivable + Prepaid Expenses to calculate your Total Assets.

Because not much has changed on the right side of you balance sheet calculate your earnings week to date = Assets – Liabilities – Original Investment – Retained Earnings.

Your Friend Has an Accident

Let’s assume that your friend had a horrible accident and didn’t pay you for the celebrity pictures. Sorry, just doing this to cover how to handle an unpaid bill. How would this effect your balance sheet?

A bad debt is considered an expense, so delete the amount in the Accounts Receivable area and reduce your Retained Earnings by the same amount.

That’s All For Now

I hope you better understand financial statements now. They really aren’t that hard to work with. In future articles I’ll continue to cover some more complex aspects of them. If you have any questions or want me to do a tutorial on one of your chosen subjects leave a comment below.

Till Next Time

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