Balance sheet

The balance sheet is a statement of the financial position and net worth of a firm. Built on the accounting equation assets = liabilities + owners’ equity, the balance sheet is a two-columned statement with ASSETS listed on the left side and liabilities and owners’ EQUITY listed on the right side. Because the right side represents the sources of CAPITAL for the firm and the left side represents the uses of that capi­tal, the two sides of the balance sheet must always be in balance.

On the asset side, current assets are listed at the top, fol­lowed by the long-term assets. The bottom of the left side of the balance sheet is called Total Assets.

On the right side of the balance sheet, liabilities—the firm’s debt—are listed at the top, followed by the equity. The bottom of the right side of the balance sheet is called Total Liabilities and Equity. The left and right-side totals will be equal in dollar amount.

There is a physical significance to the arrangement of the right side of the balance sheet, with liabilities being listed above and before the firm’s equity. This signifies and recognizes that the firm’s creditors (represented by liabili­ties) have a priority to be paid in the event that the firm should have to liquidate (due to insolvency or bankruptcy, for example). The equity owners can receive payment from liquidation only after all the creditors have been paid in full. For this reason, the firm’s equity is often referred to as the residual equity.

The idea of residual equity is also evident in the concept of net worth. With a simple transposition of the accounting equation assets - liabilities = owners’ equity, it is evident that the equity is the firm’s net worth. When debts are subtracted from assets, the residual, if any, is the firm’s net worth.

Individuals and households can construct balance sheets, just as firms do. This is most useful if one wishes to determine his or her net worth. It should be noted that net worth can be negative when the liabilities (debts) exceed the assets. If a firm has a negative net worth, it is insolvent or bankrupt. If an individual or household has a negative net worth, the expression “living hand to mouth” describes the situation more aptly.