Friday, July 14, 2006

Why does the balance sheet balance?

Actually, the balance sheet may not necessarily balance. A balance sheet that does not balance is called an unbalanced relationship.

Ok... Sorry for the bo liao joke. But just to share a fact, in most financial models built by analysts, the balance sheet does not balance and they don’t know why.

Anyways, the balance sheet balances because that is how it is defined. By definition,

Assets - Liabilities = Shareholders' Equity

Hence on the balance sheet, Assets are shown on the left, Liabilities and Shareholders' Equity are shown on the right. To illustrate, assuming one bah chor mee start-up borrowed $10,000 to buy a bah chor mee store that cost $20,000 with initial capital of $10,000. Its balance sheet would look like this:

Assets (bah chor mee store) $20,000
Liabilities $10,000
Equity (or initial capital) $10,000

Assets $20,000 - Liabilities $10,000 = Shareholders' Equity $10,000

This has to be the case because initial capital and borrowing add up to the value of the asset that the company has for it to run its business. Now assume that after 1 year, the store generates $18,000 of profits by selling tons of bah chor mee (both with and without liver). Its balance sheet would look like this:

Assets $38,000 (Store $20,000 + Cash from profits $18,000)
Liabilities $10,000
Equity $28,000

Assets $38,000 - Liabilities $10,000 = Shareholders' Equity $28,000

Again the balance sheet balances because any entry into any parts of the balance sheet would have a corresponding cancelling entry on another part. In this case, Assets increases by $18,000 and Equity by $18,000 as well.

Post a Comment