How the Balance Sheet Works | with a FUN Demo

In this video, we will cover the basics of

balance

sheet

. It is also called the statement of financial position. This is where many people get confused. I'm going to be honest with you. It confused me for many years. I'll explain it with a fun

demo

nstration. You'll see what I mean, but before we get to the fun part, let's cover the theory first. The

balance

sheet

is one of the three main financial statements. The other two are: income statement and cash flow. It is essential to know how to read a balance sheet. If you want to understand the financial health of a company, that's the place to start.

So, let's get into it. (relaxed instrumental pop music) The balance looks like this. (laser swoosh) Its purpose is to give an idea about the financial situation of the company at a given time. It does not show the flows into and out of accounts during that period. It's important to remember that. A balance sheet always only shows information at a certain point in time. It is usually the end of the financial year or, in the case of listed companies, it is also the end of a quarter or half a year. Now, in the case of Microsoft in our example, it is as of June 30, 2018.

It shows what assets the company owns, the liabilities it owes to others, and the equity that belongs to the owners. In the first Accounting Basics (laser swoosh) video in the series, I will add the link in the description of this video. We showed the balance in a T account. It looked like this. Now, Microsoft's balance sheet is not structured as a T account, but in list form. It could also be shown as a T and you can see that both sides are in balance. This way, it is easier to read. Now that we've got this out of the way, let's use a very simple example to see how these components work together.

I learned this from a fellow professor and colleague of mine at the control institute, and I really like the explanation. So, let's start with the fun part. (finger snap) (laser hiss) Let's say we start a new company. What do we need for that? Effective, right? Where do we get it from? Well, one way is that we, as owners of the company, invest our own private money into this company. That's called equity. We are going to

demo

nstrate this with a glass of water. I marked the current level of equity with a green line here, but here's the thing.

For most startups, equity capital is not enough. We need additional funds and we are going to get a bank loan. In our example, this glass of orange juice represents our bank loan. I marked the current level with a red line. Currently, we only have balances on the credit side of the balance sheet. The balance does not add up, so what is missing? The credits represent the source, that is, where the money comes from. We are missing the debits. Debits represent a destination, that is, where does the money go? Or what is it spent on? In our case we still haven't spent it on anything.

All the money went to the cash account. (relaxed instrumental jazz music) (liquid pouring) The cash account consists of the money we receive from the owners and the bank. So just by looking at the cash account, we can't tell what came from where. So how much is our own funds and how much is externally funded? It's just cash, (tapping glass) orange juice and water. What does the company do with its cash? You're probably going to invest. Maybe I'm going to buy machinery. Now, how does that affect the balance sheet? We take money out of the cash account and put it into teams. (relaxed instrumental jazz music) (liquid pouring) The total amount of assets does not change because of this.

We have less money in the bank but in exchange we have the value of the team. Now, if you start using the machine, it will lose its value because we are using it. In accounting, this is reflected in depreciation. In addition, the company incurs expenses such as personnel costs for its employees, because we have to pay salaries and wages, and these are deducted from the cash account. In both cases, the financial value of the company decreases. At the same time, our customers are happy and pay for the products and services we offer them. Then we receive money from them (liquid pour) into our cash account.

Now we want to know if in total we have increased the financial value of the company since we started. What we need to do? We need to add up the value of the assets available right now. So what assets do we have? We have the current value of the machinery, which is what we paid initially, less depreciation, that is, the decrease in value due to wear and tear, plus what we currently have in the bank. (relaxed instrumental jazz music) (liquid pouring) Those are the company's total assets. Now, from this total, we must deduct the company's debt.

We can see this with the red marker on the glass. (liquid pour) Now, if the value of the remaining assets is greater than the original capital that the owners paid, the company made a profit and increased its financial value. (liquid pouring) Let's check. If it is less, we had a loss. Now, in our case, it is higher than the green line, so we made profits and increased the value of the company. The important part of this exercise is that (laser swoosh) the glass with equity was always empty. It was right there. This is because equity alone does not really exist.

What exists are the company's assets and its debt. Equity is just a calculation of total assets minus debt. It only exists on paper. The more assets a company has and the less its debt, the greater its capital. So let that sink in. (Laser swoosh) It all comes back to the primary accounting equation: assets equal liabilities plus equity. If we rearrange this, equity equals assets minus liabilities. The higher value of assets and the lower value of liabilities equals greater wealth. I hope this fun demonstration was helpful in understanding the mechanics of balance. And I also hope you're enjoying our finance series.

Let me know in the comments below if you want me to cover a specific topic. If you liked this video, please like (pop) and if you want to improve your skills, consider subscribing (click) and don't forget to hit (bell) that bell so you don't miss anything. New videos. Thanks for watching. See you in the next video. (relaxed instrumental jazz music)