The balance sheet and equity statement
The balance sheet shows what a business owns and owes at a moment in time. The statement of changes in equity links it to the income statement.
Purpose
The balance sheet (statement of financial position) reports assets, liabilities, and equity at a specific date, such as 31 December. It reflects the accounting equation: total assets must equal total liabilities plus equity.
Classified balance sheet
A classified balance sheet groups items. Current assets are expected to become cash or be used within one year or the operating cycle (cash, receivables, inventory, prepaid expenses). Non-current assets include property, plant, and equipment, intangible assets (patents, trademarks, goodwill), and long-term investments.
Liabilities
Current liabilities are due within a year (accounts payable, wages payable, short-term loans, the current portion of long-term debt, unearned revenue). Non-current liabilities are due later (long-term loans, bonds payable, lease liabilities). Separating current from non-current helps assess short-term solvency.
Equity
For a sole proprietorship, equity is the owner's capital. For a corporation, stockholders' equity includes contributed capital (common stock and additional paid-in capital) and retained earnings, the accumulated net income kept in the business rather than paid as dividends.
Retained earnings and the equity statement
The statement of retained earnings (or statement of changes in equity) shows how equity changed: beginning retained earnings plus net income minus dividends equals ending retained earnings. It connects the income statement (net income) to the balance sheet (ending equity).
How the statements link
Net income from the income statement flows into retained earnings on the equity statement, whose ending balance appears on the balance sheet. The cash flow statement explains the change in the balance sheet's cash. Together the statements give a complete picture.
Liquidity ratios
The current ratio (current assets / current liabilities) measures ability to meet short-term obligations. The quick ratio ((cash + marketable securities + receivables) / current liabilities) excludes inventory, which may be hard to sell quickly, giving a stricter test.
Worked example
A company starts the year with retained earnings of 200,000 dollars, earns net income of 80,000, and pays dividends of 30,000. Ending retained earnings = 200,000 + 80,000 - 30,000 = 250,000. This 250,000 appears in the equity section of the year-end balance sheet, linking the statements.
Key takeaways
The balance sheet reports assets, liabilities, and equity at a date, always balancing. Classified balance sheets separate current from non-current items. Current liabilities are due within a year. Corporate equity includes contributed capital and retained earnings. Ending retained earnings = beginning + net income - dividends. The statements link: net income to equity, equity to the balance sheet, and cash flows to cash. The current and quick ratios assess liquidity.
Flashcard
Assets, liabilities, equity at a date
Check your understanding
Beginning retained earnings are 120,000, net income is 45,000, and dividends are 15,000. What are ending retained earnings?