From the course: Financial Accounting Part 2

Review of the balance sheet

From the course: Financial Accounting Part 2

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Review of the balance sheet

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- So we've discussed previously what financial statements are and how they are compiled, using debits and credits, the mechanics of accounting. Now we are going to see how financial statements are commonly used when making various decisions. In other words, we are now going to analyze the financial statements. Not surprisingly, this is called financial statement analysis. Now, there are hundred ways to analyze financial statements. We are going to stick with the basics. We will be using common scaling techniques and common ratios to see what information will reveal itself through a very basic analysis of the financial statements. But before we jump in, let's do a quick review of the three fundamental financial statements. This will be quick. If you want a more detailed review, please refer back to part one of this course. Again, this will be a quick review. We will first start with the mother of all financial statements, the balance sheet. The balance sheet is a listing of a company's assets, its resources, it's cash, its lands, its building, its inventory. Those are its assets. The other part of the balance sheet is a listing of where the company got the money to buy those assets, the liabilities and the equities. The balance sheet embodies the accounting equation, one of the greatest inventions of the human mind, invented in Italy over 500 years ago. Now, a listing of a company's assets is easy. Anybody can list assets, but the real insight of the balance sheet is then to list where did the company get the money to buy those assets. That is, what are the company's liabilities and what claims do the owners have on those assets? Keep in mind that the balance sheet is called the balance sheet for a reason. A company's total assets exactly equals the company's liabilities and the company's owner's equity. The balance sheet has to balance. Now, what are assets? Items that will probably provide benefit to a company in the future as a result of past transactions. For example, a company buys inventory to sell in the future. The inventory was purchased in the past and will be sold in the future. That is, it has future benefit, probably. Probable is a key word in accounting. Assets probably have future benefit, but there are certainly no guarantees. Floods, fires, market collapses. These and other factors can certainly change the future value of things. The financial statements don't state certainties. The items reflected on the asset side of the balance sheet are expected to provide probable future benefit. Now to the other side of the balance sheet. What are the sources used to finance its assets? One of the possible sources are liabilities. Liabilities are obligations to repay money or to provide a service in the future. If a company buys something on credit, the obligation they have to repay, that's a liability. If a company receives money now and promises to provide a service in the future, the company has a liability. A great example of this type of liability happens for Delta Airlines. When you and I fly on Delta, we pay first and fly later. In the interim, Delta owes us a ride on an airplane. That's an obligation. That's a liability. That's listed on Delta's balance sheet. The second source of financing to buy assets is owners equity. This is money provided to the company by the owners. Owners can do this in two general ways. First, the owners can take money out of their personal savings and put it into the company. They buy stock in a company. These shares of the company are called by the company, paid in capital. In other words, owners pay in capital. The second way that owners invest in a company is by keeping profits in the business. We call this retained earnings. The profits of a business belong to the owners. The owners can take those profits out and use them to buy groceries or to buy a boat or whatever else they want to buy. Or the owners can say, let's put these profits back in the business. We call that retained earnings. Paid in capital and retained earnings are the amount of money that are provided to the company by the owners to then buy assets. So a company has assets, they had to get the money to buy those assets from somewhere. The relationship between assets, liabilities, and owner's equity tell us very important things about a business, its strengths, its weaknesses, and its risks. Now we will be using the balance sheet as we practice our financial statement analysis. The balance sheet, the mother of all financial statements.

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