What is a Balance Sheet?

0:06 welcome 0:07 in this video we're going to discuss the 0:09 balance sheet that tool that's going to 0:10 give us the answer to the first big 0:12 question in life 0:13 as i promised you in our first video i'm 0:15 gonna take a common sense approach to 0:17 this 0:18 so we won't get to the accounting jargon 0:20 and definitions until near the end 0:22 let me remind you what that first big 0:24 question in life is 0:26 it's what is the financial condition of 0:28 an organization on a given day 0:30 remember this is a question that's been 0:32 asked since the beginning of 0:33 civilization 0:34 and we've come up with this tool the 0:36 balance sheet to answer that question 0:38 it does that by giving us a snapshot in 0:41 time of where the organization stands 0:44 so what do we need to know if we're 0:46 going to get that snapshot in time 0:48 well really what we need to know is what 0:50 do i have and 0:51 where did i get it from and the two of 0:54 these should be equal 0:55 if i didn't get it from somewhere then i 0:57 can't have it 0:58 this is the idea of a balance sheet 1:00 these two sides are going to balance 1:02 now if you've ever looked at a financial 1:05 statement you know that you don't 1:06 actually see a column that says what do 1:08 i have and where did i get it from 1:10 instead you see a column that says 1:12 assets that's what do i have 1:15 and then on the other side you see these 1:17 liabilities and 1:18 shareholders equity and we say those two 1:21 things equal 1:22 the liabilities and shareholders equity 1:24 are where i got things from 1:27 let's dig into the balance sheet a 1:28 little more to understand what each one 1:30 of those words means 1:31 the assets those are the things we have 1:34 that we're going to use for future value 1:36 creation 1:37 another way to think of those are that's 1:38 what i own 1:40 the liabilities those are the future 1:42 value that we're going to have to give 1:44 to outsiders 1:45 commitments that we've already made you 1:47 can think of that as what i owe 1:49 and the shareholders equity well those 1:51 are amounts that were either 1:53 directly contributed by owners or it's 1:55 value that the firm's created over time 1:58 but has not distributed back out to the 2:00 owners yet 2:02 and you can think of that as the 2:03 residual or the book value or the net 2:05 worth 2:06 you've probably stopped right now and 2:07 said wait a minute assets and 2:08 liabilities that made perfect sense 2:10 what do i own and what do i owe why for 2:14 shareholders equity are you saying 2:15 things like residual book value and net 2:17 worth 2:18 well here we can take advantage of the 2:20 fact that the balance sheet actually is 2:21 an equation 2:22 and we can manipulate it mathematically 2:24 to better understand that 2:26 so let's start with our equation assets 2:28 equals liabilities plus shareholders 2:30 equity 2:32 now we can keep our assets where they're 2:34 at but let's go ahead and subtract 2:35 liabilities from both sides of the 2:37 equation 2:38 that means on the left hand side we have 2:40 assets minus liabilities and 2:42 all that's left on the right hand side 2:44 is shareholders equity 2:46 so our assets are what we own and our 2:48 liabilities are what we owe 2:49 others the difference between those is 2:51 whatever's left over 2:52 and that's for our shareholders that's 2:55 why frequently instead of saying 2:56 shareholders equity people will use a 2:58 word like residual 3:00 book value of the firm net worth of the 3:03 firm 3:03 net book value of the firm or any other 3:06 sort of 3:07 derivation of those sort of names you 3:10 can see that 3:11 shareholders equity really just means 3:14 after i 3:14 fulfilled all of my obligations anything 3:17 else that i still own at that point 3:18 belongs to my shareholders 3:21 now i've been giving you the common 3:23 sense sort of definitions of these items 3:25 and 3:25 anytime that you start to get confused 3:27 you should go back to those 3:28 but in the cases of assets and 3:30 liabilities the standard setters 3:32 actually have spent a tremendous amount 3:33 of time coming up with 3:34 relatively simple definitions that are 3:37 robust across 3:38 a large range of situations i'm going to 3:42 take those definitions and break them 3:43 down into a couple parts to make them 3:45 even easier for you 3:46 the definition of an asset it's 3:49 something with probable future economic 3:51 benefit 3:52 now i want to stress this word probable 3:54 notice that we didn't say 3:55 certain or guaranteed future economic 3:57 benefit 3:58 it says probable that's where the 4:00 judgment comes in if you believe you're 4:01 going to get a future economic benefit 4:03 that's the first criteria for an asset 4:05 secondly obtained or controlled by the 4:08 firm 4:09 the crucial word here is controlled if 4:11 you don't control an asset 4:13 then it's hard to say you're going to 4:14 get probable future economic benefit 4:16 from it 4:17 let's think back to the corvette from 4:19 the last video 4:20 if we took that corvette from our kid 4:22 and started driving it ourselves we 4:23 might as well get some of the fun out of 4:25 it 4:26 well if every time you park that in the 4:27 parking lot somebody else is welcome to 4:30 just take it 4:30 and make it theirs because you don't 4:32 control it then it's not likely that 4:35 you're going to get future economic 4:36 benefit out of it 4:38 even though that's kind of a silly 4:39 example you can think of the same thing 4:41 in business 4:42 if you had a store but other people are 4:44 welcome to move their items in there and 4:46 sell them themselves 4:47 then again you're not controlling it and 4:49 it's not likely you're going to get the 4:51 future economic benefit from that store 4:53 there's still one more criteria for an 4:55 asset though 4:56 it has to come as the result of a past 4:58 transaction or event 5:00 you can't look into the future and say 5:02 hey i'm going to do all these great 5:03 things 5:04 that at that point will create a 5:05 probable future economic benefit and 5:07 i'll control them then 5:08 it has to be something that's already 5:10 occurred so now we have to put all three 5:12 criteria together every time we assess 5:14 whether something is an asset 5:16 does it have a probable future economic 5:18 benefit 5:19 under our control as a result of past 5:22 transaction if it meets all three of 5:24 these criteria it's an asset 5:26 if it fails any one of them it's not an 5:28 asset 5:30 similarly we have a pretty good 5:31 definition of liabilities 5:33 that only has two parts though the first 5:35 part 5:36 probable future economic sacrifice again 5:39 i really want to stress that word 5:41 probable 5:42 notice it doesn't say a certain future 5:44 economic sacrifice 5:45 but just a probable future economic 5:47 sacrifice we're back to having to make 5:49 judgment 5:50 just like in the accrual accounting that 5:52 we talked about in the last video 5:55 now not only do we have to have a 5:57 probable future economic sacrifice 5:59 but just like an asset it has to come 6:02 from a past transaction 6:03 we don't look into the future and assume 6:06 that hey because of the business we're 6:07 in 6:08 it's likely that we'll have future 6:10 economic sacrifices 6:11 for events that are going to occur in 6:13 the future rather we have to wait for an 6:16 event to have occurred in this period 6:18 and then figure out do we have a 6:19 probable future economic sacrifice 6:22 those are two pretty simple and 6:24 straightforward definitions we're going 6:25 to work with them throughout the course 6:27 and i think you're going to find they're 6:28 pretty powerful no matter how 6:30 complicated the situation you run into 6:32 in this course or in your jobs you'll be 6:35 able to apply these definitions and come 6:37 back to a pretty simple answer of 6:38 whether we have an asset or whether we 6:40 have a liability 6:41 i wish i could tell you the same thing 6:43 for shareholders equity 6:45 but i'm going to keep this one not even 6:47 in fancy colors because 6:49 we don't have a good definition for it 6:51 we're going to use the working 6:52 definition that it's the residual value 6:54 remaining after all obligations have 6:56 been fulfilled 6:58 the standard setters have been 6:59 struggling with shareholders equity 7:01 there's a lot of 7:02 complicated financial transactions that 7:04 really 7:06 sit on the line between shareholders 7:07 equity and liabilities 7:09 in a way that's beyond what goes on in 7:11 this course i feel pretty confident that 7:13 sometime hopefully soon they'll have an 7:15 equally good definition 7:17 but for the purposes of the course we're 7:18 perfectly fine just to use this residual 7:20 definition 7:22 now i'm going to do a set of videos on 7:23 shareholders equity that will clarify it 7:25 a lot more 7:26 but we're going to work basically with 7:28 this simple definition 7:30 as we move forward now before we leave 7:32 the balance sheet i just want to step 7:34 back to the big picture here 7:36 we started this whole course by saying 7:38 that accounting should provide 7:39 information to decision makers 7:41 so when would you use a balance sheet 7:43 well let's think of a couple situations 7:46 if you're trying to figure out whether 7:47 you have enough inventory to fulfill a 7:48 sale 7:49 or future sales you think you might make 7:52 if you're trying to figure out do i have 7:54 enough cash on hand to pay my suppliers 7:56 or am i overextending myself 7:59 maybe what you're trying to figure out 8:00 is how much value did i really let the 8:02 manager control during this entire 8:04 period 8:04 so i want to think about the total 8:06 number of assets they had 8:07 so that i can hold them accountable for 8:09 getting a good return for me 8:11 or we could think about it as how much 8:13 do i owe my suppliers so that i can 8:14 start thinking about cash management 8:16 going forward 8:18 maybe i want to think about how much do 8:19 i just owe in the short term to 8:21 everybody 8:21 not just to my suppliers but to my 8:23 employees 8:25 maybe bank loans that i'd borrowed long 8:27 ago etc 8:28 and of course we could think about this 8:30 question of how much value is there for 8:32 my shareholders if i'm thinking about 8:34 things like do i want to pay a dividend 8:36 or make some sort of a repurchase etc 8:38 all of those are topics we'll cover 8:40 going forward now if you look at these 8:42 two columns you'll realize 8:43 those on the left of the slides are 8:45 pieces of information you get from the 8:47 asset part of the balance sheet 8:49 and the first two on the right are items 8:51 that you'll get from the liability 8:52 component 8:53 and the final item is one that we're 8:55 going to get from the stockholders 8:56 equity 8:56 section of the balance sheet you can see 8:59 that the balance sheet can answer a 9:00 whole bunch of questions 9:02 and it's really not that complicated of 9:04 a statement if we just keep thinking of 9:05 it as 9:06 answering that big question of where do 9:08 i stand at this given point in time 9:10 in the next video we're going to break 9:12 the income statement down the same way