Balance sheets are a snapshot of an individual or companies net worth at any moment in time. Balance sheets consists of the following sections; assets, liabilities, and networth/equity. The main function of a balance sheet is to determine how much you are actually worth after you subtract the assets from the liabilities. This is known as networth, or owner equity.
Assets are both tangible and not tangible things with a given value. Most balance sheets are broken up into two or three asset categories. For this article a three category balance sheet will be used. The first asset category is your current assets. These are thing like cash, stocks that are not in a retirement account, accounts receivable, and some business inventory. These items are what are referred to as liquid. They can be converted into cash in one year or less. The current assets are located in the upper left hand corner of the balance sheet.
The second asset area are the intermediate assets. This is the category that is left out of some balance sheets. Balance sheets that are only two categories negate the intermediate assets. Intermediate assets are thing such as vehicles, machinery, cash value of life insurance, ownership in a a partnership or closely held corporation or other entity. These assets are not always easy turned into cash. Items that have have a limited useful life, usually less than ten years, such as vehicles, fit into the intermediate assets.
The final area of the asset side of the balance sheet is the long term assets. Real estate and other items that have a useful life of more than 10 years generally fit into this category. Retirement accounts generally fit into this category as well because for the majority of people they will not be withdrawing from these accounts for more than ten years. The long term assets generally will have the most value of the three major asset categories.
In order to determine your total assets you need to add the current assets, intermediate assets, and long term assets together. When placing values on the balance sheet market values are appropriate in 80% of the cases. If you would like to put together in general a more conservative balance sheet you can use a cost basis method. The cost basis method uses what was paid for the intermediate and long term assets, rather than the market value. When using cost base balance sheets you still need to determine depreciation, which will be covered in another article.
Once you have your total assets determined you now need to fill out the liabilities. In general liabilities are things such as loans, credit card balances, mortgage debt, and any comade, or cosigned loans that you may have.
Just like in the assets there are three lability categories. The first is the current liabilities. Current liabilities consists of anything money that is owed in the next 12 months. This such as credit card bills and car payment fit into this category. Although car loans and mortgage debt are intermediate and long term liabilities, the portion of those debts, both principal and interest, that is due in the next 12 months needs to be brought up to the current portion of liabilities.
The intermediate liabilities as stated earlier are thing like car loans and business loans that are less than 10 years in duration. One thing that needs to be addressed is that in both the intermediate and long term categories is that when stating a balance make sure that it is the principal balance as if it is one year from the date that you are make the balance sheet on. The reasoning for doing this is so that you don't double count some of the liabilities. This years principal and interest have already been accounted for in the current liabilities.
As you have probably figured out by now, the long term liabilities are real estate mortgages and other money owed that has an amortization of more than ten years. Once you have all three liability areas filled out you need to total them much the same as you did for the assets. This will give you the total liabilities figure.
Now that you have the meat and potatoes of your balance sheet complete what good does it do you? Once you have the assets and liabilies fill out you can determine your networth or owner equity. To do this you take your total assets minus your liabilities. This number should be positive. If it is not that means that your networth is negative and that you owe more money then all of the underlying assets are worth. In general if your networth is 50% of more of your asset value you are considered to have a strong balance sheet as an individual.
A secondary but as important common metric used in finance is called working capital (WC). WC is determined by subtracting your current liabilities from your current assets. This is a quick method in which to see if you have enough liquid funds to pay your bills. This works well in conjunction with a statement of cash flows, which will be discussed in a later article.
In coming articles I will go more in depth about assets, liabilities, and networth to help give you a better understanding of finance.