Welcome. In this video,

we're going to wrap up our comprehensive accounting cycle example.

We're going to talk about making a balance sheet.

Remember, that's the financial statement that tells us where we are at any point in time.

By the time we get to making a balance sheet,

we've already gone through most the steps of the accounting cycle.

Recall that during the closing process,

we summed up the asset,

liability and equity accounts.

So, all that we need to do now is take those accounts and

put them into a format that makes them the most useful for decision makers.

This means each category, assets,

liability and equity gets its own section on the balance sheet.

Within each of these sections,

we're going to order the accounts based on their liquidity,

and we're also going to some each section to make it

easier for people to pull information off quickly.

Finally, usually liabilities in equity are summed

together so that people can quickly see that our balance sheet actually does balance.

That is, our liabilities and equity equals our assets.

If we're to do all that,

here's what the Libra of wisdom balance sheet would look like.

Let me point a few details out to you.

First of all, notice the totals at the bottom.

That's the total I was just talking about,

we've got total assets and total liabilities in equity.

These two equal each other so our balance sheet does balance.

That's always a good check to start with.

Now, let me point out some other details of this balance sheet.

First of all, I mentioned that we're going to sum each section.

Well, you'll see here that the total assets,

the total equity and the total liability are all summed.

You can very quickly look at this and say,

"how much of my assets come from being

provided by people that I'm going have to pay back in the future?"

In this case, it's 67000 of the 230000.

You also could say, "how much of my equity holders put into this firm?

Oh, it's 163000.

How many total things do I have to create value?

It's 230000."

There's some there to make it really easy for you to grab those numbers.

Now, we also do some subcategory summing.

Notice the current asset number here of 195000.

Current assets are the assets that we expect will cycle back into cash within a year.

So this is saying we've got $195000 of assets that either are currently cash,

or we expect we'll turn back into cash within the next coming year.

Similarly, we have current liabilities in this case, of 45000.

Let's say we have $45000 worth of

obligations that we're going to have to fulfill within the next year.

Okay. Now, let's break down some of

the sections and take a closer look at each one of them.

We can start with the asset section.

The first thing I want you to notice here is,

that items are ordered by liquidity.

That is, how close are they to being cash?

You'll notice that our very first item in fact, is cash.

It's really close to being cash since it actually is.

The next item though, is accounts receivable.

Those are the amounts owed to us by our customers,

we expect them to pay them off pretty soon.

And so, that gets put just below cash in order of liquidity.

Following that is inventory,

we're going to have to sell that inventory.

Usually, people are going to promise to pay us in

the future creating more accounts receivable,

and then we collect on that it turns into cash.

So the inventories a little less liquid than

the accounts receivable in most cases and thus,

gets put below it on the balance sheet.

Next we have our prepaid rent.

You may recall that that's the rent for the next five months.

We're still calling it a current asset because that's within a year.

But each month, we're going to use up

that warehouse a little bit in order to sell some inventory.

And then after we sell the inventory,

we're going to get an accounts receivable then we're going to wait for

the accounts receivable to be paid off to get cash.

So you can see the liquidity order here is really helping us

to see how each one of these fits into the firm's business model.

Now, once we've added up all of those,

we have our total current assets.

That's a useful number because,

remember that's the item that tells us,

"this is the amount that's going to turn back into cash within one year."

But of course, we also have assets that are going to last longer than a year.

In this firm, we have property plant and equipment.

Remember, we said that should last three years and we've only operated for one month.

So, we've got a long time left on that item.

We don't happen to have any other long term assets here, some firms might.

Once you add those long term assets of the current assets,

that gives us our total assets.

Now, let's take a look at our liabilities.

Again, you're going to notice that they're in order of liquidity.

Remember those wages payable are actually due to be paid tomorrow.

So, that's going to have to be turned into cash pretty quickly.

We also have these accounts payable,

people loaned that to us throughout

the last month and we promised to pay within three months.

So, those may have up to two months left on them,

maybe some of them have a little less than that.

When you sum that, that gives us our current liabilities,

all the amounts we think we're going to have to pay within the next year.

We also have that notes payable,

that's the amount that we promised we would pay in

three years related to that equipment that was going to last three years.

We tried to match that financing to the life of

the equipment so that as the equipment creates value,

it will build up the value we can use to pay off that notes payable.

Because it's a long term liability, that is,

we're going to pay it off in more than a year,

it shows up further down on the balance sheet.

There could have been other long term liabilities but there weren't in this case,

so we can end that long term liability to

our current liabilities and that gives us our total liabilities.

Now we can move on to the final section of the balance sheet;

The shareholders equity section.

Now, I told you they're all ordered in liquidity,

this one actually isn't though.

It's by the form that the value was acquired.

Remember, our shareholders paid in capital 100000.

That was the value they put directly into the firm.

And then over the year,

we created value, we had net income of 75000.

We did pay out some dividends 12000 worth.

So we've actually retained earnings of $63000.

These two categories combined create our total equity.

Now that you understand all the components of the balance sheet,

we should start asking ourselves the more interesting questions;

What can we really do with this information?

How can it be helpful to decision makers?

Well, since I've been talking about liquidity,

let's just start thinking that way.

Maybe what we want to ask ourselves is,

we've got these current liabilities of $45000,

that means we're going to have to pay them off within a year.

Well, are we comfortable we can do that?

Well, notice we also have these current assets of $195000.

Those are things that are going to turn into cash within a year.

We could just ignore everything else then and say,

"let's take these summary measures to get some sense of our liquidity stance."

We can create a ratio to do that.

I'm going to call it the current ratio,

you might call it something else, that's fine.

The important thing is that we're going to compare our current assets to

our current liabilities to figure out whether

we have enough assets to fulfill our liabilities.

To do that, we put down 195000 of

current assets we have and the 45000 of current liabilities.

It turns out our current ratio is 4.33.

What this means is we have

$4 and 33 cents of current assets for every current liability we have.

Another way to think of this is,

we believe that for every dollar we're going to have to pay out to people that we owe,

we're going to have $4 and 33 cents

during this year with which we could fulfill that debt.

That makes it feel like we're in pretty good shape.

Of course, you might look back at the balance sheet and say,

"whoa, wait a minute,

those wages payables are due tomorrow and the accounts payable are due within two months.

And just a couple of slides ago,

you were telling me the prepaid rent's going to take at least five months to pay off."

In a situation like that,

you might say, "you know,

what would happen if actually I can't make future sales,

I'm stuck with this inventory and people don't want to pay me back.

What's the most conservative thing to think?

Do I just have enough cash to cover my liabilities?"

Well, we can do that,

just focus on the cash in those very short term liabilities.

People often call that the quicker asset ratio

and it's going to be a similar sort of ratio,

we're just going to put cash over all those current liabilities.

This one is going to look different though,

we have 40000 of cash and 45000 of liabilities.

That means we only have 89 cents for

every dollar that we're going to owe people moving forward.

That makes us think maybe we should go back and reassess our balance sheet and say,

"how comfortable are we about some of these other assets helping to meet our obligations?

That is, what do I have that I can really use to pay this off?"

Now, we've already talked about the cash,

we could pay with that.

And then that's gone but it's only

40000 so we still have 5000 more that we have to fulfill.

As you look at the balance sheet, you say, "well,

the next most liquid thing is accounts receivable and it's a 105000.

It seems like I should feel pretty comfortable that

I can get at least another 5000 out of that.

Of course, I might have a problem if part of the way I made

all these sales was by giving people really long payment terms.

Take the books now, you can pay me in a year."

If that's the case,

then these really aren't as liquid as we thought,

or maybe we gave books to a bunch of people who were really shady credit risk,

and now we're starting to realize they may not pay us.

Again, then they're not as useful as we thought they'd be.

So what happens if we can't rely on those accounts receivable?

Well, our next assets are inventory.

We could take a look at that and say, "well,

we probably can't pay our vendors in inventory,

but maybe what we could do is make some cash sales.

We could offer big discounts to people if they pay us cash right away so that

we can get that other $5000 and change our ratio a little bit."

Now, what happens if this inventory hasn't sold

because nobody really wants to read those books?

Well then that's gone too.

Now we're stuck.

We've only got a couple of assets left.

That prepaid rent, that covers having five more months worth of warehouse.

If we're not selling books out of it or collecting what people owe us,

it's tough to see how that's going to generate the cash for us.

Well, what about the property, plant, and equipment?

Remember that was things like racks,

or a forklift to move the books around.

So again, if we can't be using our inventories to generate value,

it's not clear that asset is going to help us either.

Given how much we had in accounts receivable and inventory,

we probably don't have a concern but you can see how the balance sheet

and working through the balance sheet helps to

give us information to understand where we stand,

and how we might want to think about how to manage our business.

Now, as you look at this balance sheet,

there's all sorts of other questions we could ask and answer with it.

I've just focused on liquidity.

As we work through the course,

I encourage you to keep thinking about

what sort of questions would I answer with the balance sheet.

But I want to move on to digging into each of these items in detail,

because that's really going to help you better understand them.

So, let's start working on some other videos where we can do that.

Making a Balance Sheet

Accounting for Decision Making

Meet the Instructors