Now let's move on the topic of liabilities.
Liability are financial obligations owed to those outside of the company.
Similar to assets, liability are divided in to two distinct categories.
Current, meaning those obligations that are due in a time period of one year or
less and long-term, which is a status given to those obligations that are owed
at a point past the one year time horizon.
Some examples of current liabilities that are typical for
a small business are accounts payable or money owed to vendors and suppliers.
Credit card debt or another form of short-term debt note and
the interest owed on a long-term debt such as a mortgage.
Long-term liabilities would often include examples like
the mortgage principle on real estate, bank notes for equipment purchases.
Other items could include interest owed such as a convertible debt financing
instrument, which we'll cover later in this module.
Now that we have calculated our liabilities,
we'll move on to the last category which is owner's equity.
Now, we need to address owner's equity,
which is the balancing component of our formula.
Think of it this way, at this point in time, we own 465,000 worth of assets in
our hypothetical company we've created and we've incurred liabilities of $217,800.
Could this be possible?
How can we buy that many assets but only incurring that much in liabilities?
The answer is no.
How did we get these assets?
The answer is we had to pay the balance with investment money,
also known as equity.
The reality is that most of us will start a business with only our own cash, which
is why we're not diving into the depths of the topic of shareholder's equity.
In the example provided here, we have a line for equity paid by the owner,
as well as a line item for equity paid by an investor, most likely a close friend or
family member, in this case.
Now we can close out our balance sheet exercise to confirm, in fact,
that the numbers do balance.
The balance sheet on its own may not seem like that powerful of the tool but
I assure it is.
One, it provides a picture of the financial structure of the company.
Two, it can also provide a feel for the financial health of the company.
One big use for ratio that can be extracted from the balance sheet is
the company's dept to equity ratio.
This ratio can indicate whether a company maybe at risk due to borrowing
too much capital to operate.
And thirdly, the balance sheet also provides some insights into the liquid
value of the company.
Which is often helpful for
investors and lenders because they tend to get an understanding
of what assets are worth in case of bankruptcy or a company restructuring.
As with the income statement,
the balance sheet is another tool that really only becomes
real as you build your own or explore the examples available to you on the web.
So, get exploring, keep learning about the topic but
most importantly, start building your own right now.
We'll see you in Lesson 4, where we'll the topic of cash flow.
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