The Balance Sheet (BS), also known as the Statement of Financial Position (SOFP), provides a snapshot of a company’s financial situation. It lists the value of everything a business owns (its assets) and everything the business owes (its liabilities). The equation underpinning the Balance Sheet is:
Assets = Equity + Liabilities
All financial events in the life of a company must be accounted for through the recording of two corresponding entries in the Balance Sheet. Company assets (which form one side of the Balance Sheet) must have been supported through the use of some sort of financing (detailed on the other side of the Balance Sheet), either in the form of capital (equity) or through the company taking on debt (liabilities).
- Asset: something of value to a company. Tangible assets include machinery and factories. Intangible assets include intellectual property rights, customer loyalty and knowledge. On a Balance Sheet, it is generally the tangible assets that are accounted for.
For example, if a company raises £1 million through selling shares and takes out a loan of £1 million when it first incorporates (starts up and registers as a company), its total assets will amount to £2 million.
- This £2 million will be recorded as:
(a) £2 million cash in the ‘Current Assets’ section of the Balance Sheet; and
(b) £1 million in the ‘Equity’ (share capital) section and £1 million in the ‘Liabilities’ section on the other side of the Balance Sheet.
- If the company subsequently purchases a building for £500,000, then cash (on the ‘Assets’ side) will reduce to £1.5 million and a new category will be created (also on the ‘Assets’ side), typically called Plant, Property & Equipment, the value of which will be £500,000.
- In the meantime, the Equity and Liabilities side of the Balance Sheet will remain unchanged as no new share capital has been received and no new debt has been taken on.
- If £500,000 of the loan is then paid off using cash, the ‘Assets’ section will decrease by £500,000 (to reflect the fact that cash has been spent on paying off the debt) and there would be a corresponding decrease in the ‘Liabilities’ section (to reflect the fact that the value of the outstanding loan has reduced to £500,000).
The Balance Sheet is essential in investment banking for the financial analysis of a company, as it contains information on the company’s capital structure. There is a typical example of a Balance Sheet on the next page.
- Capital Structure: this refers to the proportion of a company’s capital (financial resources) that is attributable to debt and the proportion of the company’s capital that is attributable to equity. This in turn can affect a company’s ability to raise additional capital or its attractiveness to investors. For instance, a company that is highly in debt will be perceived as a riskier investment by potential lenders or investors.
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By Jake Schogger - City Career Series