The Balance Sheet is one of the four required financial statements that accountants prepare for business owners and managers. This statement shows the assets, liabilities, and the owner's equity (capital).
The balance sheet is a reflection of the Accounting Equation (Assets = Liabilities + Owner's Equity). The accounting equation is a simple-minded equality. It informs the reader of the balance sheet to whom the assets (left side of the equation) belong: the creditors (liabilities) and the owner (owner's equity).
So, in all businesses, the two parties that can claim ownership of the assets are creditors and the owner. And in the case of a corporation 'the owner' will be many and are called shareholders.
What is a classified balance sheet?
A classified balance sheet contains two important sections: Current Assets and Current Liabilities. For accountants, the word 'current' means in general: one year. In the case of current assets it means that these assets will be used or converted into cash during the current fiscal year. In the case of current liabilities, it means that this type of liabilities will have to be paid during the current fiscal year.
By matching the current assets and the current liabilities accountants derive two important measures of financial strength; especially, in measuring liquidity (the ability to pay maturing obligations):
1. Working Capital is the excess of current assets over current liabilities.
WC = CA - LC
$150,000 = 180,000 - 90,000
The working capital ($150,000) is given in dollars.
2. Current Ratio is the ratio we find when we divide the current assets by the current liabilities.
CR = CA/CL
CR = $180,000 $90,000
CR = 2:1
The current ratio 2 simply means that for every dollar the business owes in current liabilities, it has 2 to pay them with. A well-run business will strive to have a CR that is equal to 2 (or in its full expression 2:1).
As we can see from the above illustrations, the working capital gives the reader a very limited insight into the strength of the company. $150,000 might be large to a very small business, or small to good size business. In all cases the WC must be positive. A company with a very small or negative working capital might find it hard to carry out its day to day activities.
The current ratio is a more universal measure and it allows accountants and business people to compare its current ratio with other companies. If the ratio is in the vicinity of 2 (let's say 1.98 or 2.12), then we can rest assured that we are doing a good job in managing the business.
If the current ratio is low (let's say 1.15), then it's time to either sell some non-current assets or obtain a long term loan.
Brief exercise:
If a company's balance sheet shows $180,000 in current assets, and it owes $60,000 in current liabilities --what is its working capital? What is its current ratio?
If you computed $120,000, and 3:1, respectively, then you've mastered these two concepts.
The balance sheet is a reflection of the Accounting Equation (Assets = Liabilities + Owner's Equity). The accounting equation is a simple-minded equality. It informs the reader of the balance sheet to whom the assets (left side of the equation) belong: the creditors (liabilities) and the owner (owner's equity).
So, in all businesses, the two parties that can claim ownership of the assets are creditors and the owner. And in the case of a corporation 'the owner' will be many and are called shareholders.
What is a classified balance sheet?
A classified balance sheet contains two important sections: Current Assets and Current Liabilities. For accountants, the word 'current' means in general: one year. In the case of current assets it means that these assets will be used or converted into cash during the current fiscal year. In the case of current liabilities, it means that this type of liabilities will have to be paid during the current fiscal year.
By matching the current assets and the current liabilities accountants derive two important measures of financial strength; especially, in measuring liquidity (the ability to pay maturing obligations):
1. Working Capital is the excess of current assets over current liabilities.
WC = CA - LC
$150,000 = 180,000 - 90,000
The working capital ($150,000) is given in dollars.
2. Current Ratio is the ratio we find when we divide the current assets by the current liabilities.
CR = CA/CL
CR = $180,000 $90,000
CR = 2:1
The current ratio 2 simply means that for every dollar the business owes in current liabilities, it has 2 to pay them with. A well-run business will strive to have a CR that is equal to 2 (or in its full expression 2:1).
As we can see from the above illustrations, the working capital gives the reader a very limited insight into the strength of the company. $150,000 might be large to a very small business, or small to good size business. In all cases the WC must be positive. A company with a very small or negative working capital might find it hard to carry out its day to day activities.
The current ratio is a more universal measure and it allows accountants and business people to compare its current ratio with other companies. If the ratio is in the vicinity of 2 (let's say 1.98 or 2.12), then we can rest assured that we are doing a good job in managing the business.
If the current ratio is low (let's say 1.15), then it's time to either sell some non-current assets or obtain a long term loan.
Brief exercise:
If a company's balance sheet shows $180,000 in current assets, and it owes $60,000 in current liabilities --what is its working capital? What is its current ratio?
If you computed $120,000, and 3:1, respectively, then you've mastered these two concepts.
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