Unit 3 · Topic 3.7 · about 30 minutes
The Balance Sheet and Net Worth
Read a balance sheet to judge a business's net worth, working capital and debt level, and calculate a household's net worth from what it owns and owes.
Predict first
Two bakeries in the same town report what they own and what they owe.
- Sunrise Bakery owns ovens, a building and cash worth $900,000.
- Sunrise owes $860,000 to its bank and suppliers.
- Corner Loaf owns ovens, equipment and cash worth $250,000.
- Corner Loaf owes $90,000.
Which bakery is worth more to its owners?
A snapshot of what a business owns and owes
A balance sheet compares a business's assets with its liabilities and owners' equity at a specific point in time, such as the last day of a quarter or a year. That is the big difference from an income statement, which covers a period of time. An income statement is a video of the year. A balance sheet is a photo of one day.
Assets are everything of value the business owns. Liabilities are its debts and other obligations. Owners' equity is the difference between them, the net worth of the business to its owners. The balance sheet equation, also called the fundamental accounting equation, ties the three together:
Assets = liabilities + owners' equity
So owners' equity is always assets minus liabilities. A balance sheet usually shows the same date from a previous year, or from several years, in columns side by side, so readers can see what changed.
Assets, liabilities and owners' equity
Assets are grouped by liquidity, the ease with which an asset can be turned into cash.
- Current assets are highly liquid: cash, short-term investments, accounts receivable (money customers owe the business) and inventory. They fund the business's day-to-day operations.
- Long-term assets are less liquid. They include long-term investments and fixed assets, such as production plants and the equipment used to run the business.
- Intangible assets, such as patents, brand names and trademarks, are not physical items. They have value because they represent potential revenue.
Liabilities are grouped by when payment is due.
- Current liabilities must be paid within one year. They include accounts payable (money the business owes its suppliers), short-term debt, the payments on long-term debt that come due within the next year, and accrued operating expenses, which are costs already run up but not yet paid, such as wages that office staff have earned since their last payday.
- Long-term liabilities, such as mortgages, bank loans and long-term bonds, are obligations to pay beyond one year.
Owners' equity is often made up of stock, the money owners put in for their shares, and retained earnings, the business's cumulative profits that were not paid out as dividends. When Northside Coffee earned its $19,592 net profit in the income statement lesson, whatever part it did not pay out as dividends was added to its retained earnings. That is how the two statements connect.
Sort it
Ridgeline Boards makes snowboards. Tap each item from its records, then tap where it belongs on the balance sheet.
Current asset
Long-term asset
Intangible asset
Liability
| December 31 | This year | Last year |
|---|---|---|
| Cash | $24,000 | $51,000 |
| Accounts receivable | $58,000 | $34,000 |
| Inventory | $96,000 | $70,000 |
| Total current assets | $178,000 | $155,000 |
| Factory and equipment (fixed assets) | $410,000 | $410,000 |
| Patent and brand name (intangible assets) | $30,000 | $30,000 |
| Total assets | $618,000 | $595,000 |
| Accounts payable | $52,000 | $30,000 |
| Short-term debt | $25,000 | $0 |
| Current payments on long-term debt | $21,000 | $21,000 |
| Accrued operating expenses | $8,000 | $6,000 |
| Total current liabilities | $106,000 | $57,000 |
| Mortgage on the factory (long-term) | $226,000 | $247,000 |
| Total liabilities | $332,000 | $304,000 |
| Stock | $150,000 | $150,000 |
| Retained earnings | $136,000 | $141,000 |
| Total owners' equity | $286,000 | $291,000 |
| Total liabilities and owners' equity | $618,000 | $595,000 |
What the balance sheet tells its readers
Internal stakeholders, such as owners and managers, and external stakeholders, such as lenders and investors, all use the balance sheet to judge a business's financial condition at a point in time.
- Is net worth positive? If liabilities are larger than assets, owners' equity is negative: the business owes more than everything it owns.
- Is there enough working capital? Current assets should meet or exceed current liabilities. Bills due within the next year are paid from cash and from assets that will soon become cash, not from a factory.
- Is the debt level normal? A business that owes far more than similar businesses is a riskier place to lend or invest.
When a business cannot get enough current assets to fund its operations, its owners may shut it down or pursue bankruptcy. Bankruptcy is a legal process in which a business, under legal supervision, can liquidate (sell off) its assets, eliminate or repay its debts, and then either shut down or reorganize and keep going.
Worked exampleReading Ridgeline's balance sheet
Use Ridgeline's balance sheet above. Similar snowboard makers owe about half of what they own. Is Ridgeline in good financial condition at the end of this year, and what changed since last year?
Check that it balances. Liabilities plus owners' equity are 332,000 + 286,000 = $618,000, the same as total assets.
Net worth. Owners' equity is $286,000, so Ridgeline has a positive net worth. It is $5,000 lower than last year because retained earnings fell, which means Ridgeline either lost money this year or paid out more in dividends than it earned.
Working capital. Current assets minus current liabilities is 178,000 minus 106,000 = $72,000, so Ridgeline has enough working capital to fund its day-to-day operations. Last year it was 155,000 minus 57,000 = $98,000, so the cushion is $26,000 thinner.
Debt level. Ridgeline owes $332,000 against $618,000 of assets, about 54%. That is close to the half that similar snowboard makers owe, so its debt level looks normal.
What changed. Cash fell by more than half while accounts receivable and inventory grew. Ridgeline also owes its suppliers more and took on new short-term debt. More of its money is tied up in boards it has not sold and in bills customers have not paid.
Ridgeline is in reasonable shape: a positive net worth, enough working capital and a normal debt level. But its cash is shrinking, so a lender would want to know why inventory and receivables grew so fast.
Net worth for a household
The same subtraction works for a family. Personal net worth is usually calculated for a whole household, which may include more than one person. Add up everything the household owns, including savings and investments, property and personal possessions, then subtract everything it owes.
Net worth can be negative. A recent graduate whose student loans are larger than everything she owns, her savings and her car included, has a net worth below zero.
Lenders may ask for a household's net worth when it applies for a loan, such as a mortgage. Consumers and financial planners also look at net worth to judge whether someone has enough savings to retire.
Worked exampleThe Ortiz household's net worth
Ana and Luis Ortiz add up their household's finances.
What they own
- Checking and savings: $11,500
- Retirement accounts: $64,000
- Home (current value): $285,000
- Car (current value): $16,000
- Furniture and other possessions: $9,000
What they owe
- Mortgage balance: $221,000
- Car loan: $7,500
- Student loans: $14,000
- Credit card balance: $2,300
What is their household net worth?
Add the assets. 11,500 + 64,000 + 285,000 + 16,000 + 9,000 = $385,500.
Add the liabilities. 221,000 + 7,500 + 14,000 + 2,300 = $244,800.
Subtract. Net worth = assets minus liabilities = 385,500 minus 244,800 = $140,700.
Their household net worth is $140,700. The home counts as an asset at its current value, and the mortgage counts separately as a liability. Leaving out the mortgage would overstate their net worth by the whole mortgage balance.
Check your understanding
A hardware store's balance sheet shows these totals.
- Total assets: $480,000
- Owners' equity: $190,000
What are its total liabilities, in dollars?
Last year a bakery took out a 10-year loan to buy a new oven, and it repays the loan in monthly payments. How is that loan shown on its balance sheet today?
A furniture store's balance sheet shows these totals.
- Total assets: $400,000
- Total liabilities: $250,000
- Current assets: $45,000
- Current liabilities: $62,000
What does the balance sheet indicate?
A couple in their late fifties meets a financial planner for the first time. Why would the planner calculate their household net worth?
A corporation's results for the year:
- Net profit: $80,000
- Dividends paid to shareholders: $30,000
If nothing else affected them, how did its retained earnings change?
Course alignment, for teachers
AP Business with Personal Finance topic 3.7, Unit 3: Personal Saving and Borrowing / Business Finance and Accounting.