We will reject interesting opportunities rather than over-leverage our balance sheet.
- Warren Buffett
The balance sheet is a snapshot of assets on a specific date. Our finance department gives me this report every month, showing the company's asset situation on the last day of the previous month.
The balance sheet includes assets, liabilities, and owner's equity, where
Assets
are economic resources that the company can control
Being controllable does not mean ownership, such as leasing; for example, resources of a company with more than 50% controlling interest, although not 100% owned, are 100% controlled, so the assets of the holding company are fully included in the group's assets.
may bring future benefits to the enterprise
Cost and value can be reliably assessed
Includes current assets and non-current assets (depending on whether they can be converted into cash within one year)
Includes: cash, accounts receivable, investments, inventory, work-in-progress, intangible assets, fixed assets, etc.
Liabilities
Confirmed obligations
Arising from past events
Will be settled in the future through outflow of assets
Settlement value can be reliably assessed
Reflected in creditors' assets
Includes: accounts payable, debt, committed wages, committed dividends to be paid, warranty claim reserves
Owner's Equity
Equals assets - liabilities
Includes: share capital, capital reserve, surplus reserve, undistributed profits, etc.
For our small company, and being an internet company, I pay more attention to cash, accounts receivable, and accounts payable. Cash flow is still the most important; having revenue and assets doesn't necessarily mean safety because we also need to look at cash flow. I always read Jeff Bezos' letters to shareholders, which emphasize Free Cash Flow. I will elaborate on this concept when I share the working capital concept later.
The purpose of the balance sheet:
Display financial condition
Determine if there are sufficient assets to repay debts.
There are two concepts here: solvency and liquidity
Solvency | Liquidity |
Solvency ratio | Liquidity ratio |
Solvency | Debt-paying ability |
Ability to fulfill financial responsibilities | The ability to repay long-term and short-term debts with its assets |
Measure the company's financial condition | Reflects the company's financial condition and operating capacity |
Long-term solvency | Short-term debt repayment of funds flow |
Solvency = Total Liabilities / Total Assets | Liquidity = Current Assets / Current Liabilities |
* Here's another point to add: double-entry bookkeeping
My mom is an accountant, and when I was little, she told me about "double-entry bookkeeping," meaning "there must be a debit for every credit, and debits must equal credits."
Double-entry bookkeeping uses the balance between assets and equity as the basis for bookkeeping. For each economic transaction, amounts are recorded equally in two or more interconnected accounts, systematically reflecting the results of changes in the movement of funds. Double-entry bookkeeping is a specialized method for registering each economic transaction through two or more related accounts. Any economic activity will cause changes in the increase or decrease of funds or financial income and expenditure.
All double-entry bookkeeping ledgers have the same structure: divided into two columns, one column records the increase in amount, and the other records the decrease in amount. As long as the company has business activities, they are respectively recorded in two ledgers (or even more ledgers). When it's time to produce financial reports, these ledgers are consolidated to form the "balance sheet" and "income statement." With some analysis and calculation, the "cash flow statement" and "statement of changes in owner's equity" can be derived. Adding a textual explanation ("notes"), an annual financial report is completed, called "four statements and one note."
I'll continue tomorrow with the income statement.