The Balance Sheet: How Solid Is the Foundation?

Assets = liabilities + shareholders' equity

The balance sheet is a snapshot of what a company has at one moment: its assets, part of which were paid for with borrowed money (liabilities), and the rest belongs to shareholders (shareholders' equity).

Debt cuts both ways

Borrowing to expand magnifies shareholder returns in good years; in bad years, the losses land entirely on shareholders' equity. A current ratio below 1 means the company owes more within a year than it can turn into cash.

Two ways to raise money

Borrowing: assets and liabilities both rise, equity stays the same, and the debt ratio goes up. Issuing new shares: assets and equity both rise and the debt ratio falls, but existing shareholders' stakes are diluted.

Key takeaways

• Assets = liabilities + shareholders' equity. Borrowing to buy assets grows both sides at once.
• Current ratio = current assets ÷ current liabilities, a measure of the ability to pay short-term debts. A current ratio propped up by accounts receivable deserves a discount.
• Borrowing raises the debt ratio; issuing new shares lowers it but dilutes existing shareholders.
• When assets lose value, liabilities don't shrink by a cent, so shareholders' equity absorbs the whole loss. The more debt, the less a company can withstand losses.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Click “Take a 200 long-term loan to buy equipment”: how much did each of the two bars grow? Did shareholders' equity change?
2. After resetting, click “Issue 150 in new shares”: what does the debt ratio change from and to?
3. After resetting, click “Lose 250” once: what does shareholders' equity drop to from 400? How high does the debt ratio rise? Why can't you click it a second time?
4. After resetting, click “Sell 150 on credit” twice: not a cent more cash, yet what does the current ratio change to from 2.00?

Quiz and explanations

1. Assets are $500 and liabilities $300. What's shareholders' equity?

Answer: $200.$500 − $300 = $200.

2. A company borrows $100 to buy equipment. The balance sheet will show…

Answer: Assets up $100, liabilities up $100.The borrowed money becomes equipment, so assets and liabilities both rise.

3. Assets are $1,000 and liabilities $600. If asset values fall 20%, what does shareholders' equity become?

Answer: $200.Assets become $800 while liabilities are still $600, so equity = $200, half of the original $400. Assets fell only 20%, but equity fell 50%.

Terms in this lesson

• assets (Assets): Resources a company owns that bring economic benefit, such as cash, receivables, inventory and plant and equipment.
• balance sheet (Balance Sheet): At a moment in time, what a company owns (assets), what it owes (liabilities) and what belongs to shareholders (equity).
• current ratio (Current Ratio): Current assets ÷ current liabilities, a measure of the ability to pay debts due within a year; above 1 is usually safer.
• liabilities (Liabilities): Money a company owes others, such as loans and accounts payable.
• shareholders' equity (Shareholders' Equity): What's left after subtracting liabilities from assets, which belongs to shareholders; also called net assets.