Balance sheets are one of the primary statements used to determine the net worth of a company and get a quick overview of it's financial health. The ability to read and understand a balance sheet is a crucial skill for anyone involved in business, but it's one that many people lack.

When it comes down to it, the balance sheet is just a more detailed version of the fundamental accounting equation:

Assets = Liabilities + Equity

You've probably heard at least some of these terms before but what do they actually mean? Let's break it down:

Assets

The assets are the operational side of the company, basically a list of what the company owns. Everything listed there is an item that the company has control over and can use to run the business. 

In a sense, the left side of the balance sheet is the business itself – the buildings, the inventory for sale, the cash from selling goods, etc. If you were to take a clipboard and record everything you found in a company, you would end up with a list that looks remarkably like the left side of the Balance Sheet. The assets are what allow the company to run.

Liabilities 

Liabilities and equity make up the right side of the balance sheet and cover the financial side of the company. This is a list of what the company owes. With liabilities, this is obvious – you owe loans to a bank, or repayment of bonds to holders of debt, etc. The interest rates are fixed and the amounts owed are clear. These are also listed on the top because, in case of bankruptcy, these are paid back first before any other funds are given out.

Equity

Below liabilities on the balance sheet, you'll find equity, the amount owed to the owners of the company. Since they own the entire company, this amount is intuitively based on the accounting equation – whatever is left over of the Assets after the liabilities have been accounted for must be owned by the owners, by equity. These are listed on the bottom, because the owners are paid back second, only after all liabilities have been paid. 

However, unlike liabilities, equity is not a fixed amount with a fixed interest rate. This means that any time the value of assets change – perhaps you receive more in cash from a sale than the value of the inventory you sold, or you were forced to write-down a truck that was involved in a collision and no longer works – the value of equity changes. 

Because the value of liabilities is constant, all changes to assets must be reflected with a change in equity. This is also why all revenue and expense accounts are equity accounts, because they represent changes to the value of assets. 

Make sense?

So, to recap, you'll find the assets (what's owned) on the left of the balance sheet, liabilities (what's owed) and equity (the owner's share) on the right, and the two sides remain balanced by adjusting the value of equity. And there you have it!

Want to dive deeper into balance sheets, assets, liabilities, and equity? Check out HBX CORe, the online fundamentals of business program from Harvard Business School!

Imagine a man who sells apples on the side of the road out of a cardboard box. Every morning, he buys some apples at the grocery store, then walks to his corner. He sells the apples for $1 each until he runs out, then heads home for the day.

For the apple seller, accounting is easy. If he wants to know his balance sheet, he looks down in front of him. There are some apples (his inventory) and a cardboard box (his property, plant, and equipment). If he reaches into his pocket and counts the number of dollar bills he has, that’s his cash. Together, those are all of his assets. His equity is exactly equal to his assets – he didn’t borrow any money to buy the apples or the cardboard box in the morning, so he has no liabilities. He can do this whenever he wants to get the current balance sheet of his business. His income statement is just as easy – he remembers how much money he had in his pocket before he left home this morning, and counts how much he has now. The difference is his net income for the day.

One day, a truck of workers passes by and they offer to buy his entire box of apples, but they’ll need to pay him tomorrow. For the apple seller, this is a great deal – he could go home early if he agrees and spend more time with his family, or he could use the money to buy more apples and make a lot more money today. But he would need to keep track of how much the workers owe him for the apples, so he writes a note on the side of his cardboard box. The next day, as he’s buying apples, the man at the counter in the grocery store says, “You know, you buy apples from me every day. You’re my best customer – why not just pay me once a week? That would be easier.” So he starts writing on the side of the box how many apples he buys each day, so he knows how much to pay at the end of the week.

This is an example of accounting in action. The marks on the side of that cardboard box are the beginnings of T-accounts – recording his accounts receivable and his accounts payable – and this apple seller is still running an extremely simple operation. If he opens a bank account, because he’s worried about being robbed while he stands on the side of the street, he’ll need some way to record that. If he decides to hire his son to sell apples two streets over, he’ll need to keep track of how many apples his son has sold and how much to pay him. Suddenly, he can’t generate his balance sheet just by looking in his box.

Very quickly, the benefits to accounting become apparent. Accounting gives us a standardized way to keep track of all of these things, so you can quickly and easily understand your business.

Want to learn more about accounting, economics, and analytics? Check out HBX CORe, an interactive online program from Harvard Business School! 

Some companies have incredibly powerful brands – Forbes calculates the value of Apple’s brand, the most valuable in the world, at $145.3 billion. The value of the next two most valuable brands are much less, but still impressive (Microsoft at $69.3 billion and Google at $65.6 billion). Yet none of these three companies list this incredibly valuable asset - their brand - on their balance sheets. They’ve spent years to make these brands strong – why not record their value?The money measurement principle of accounting suggests that only items that have a certain defined value are tracked in the balance sheet, which is why brands don’t appear. But does that make sense? Forbes has clearly provided a value for these brands, and Forbes is a respectable publication – couldn’t the companies just list this value? 

Not really. First of all, the brand valuation provided by Forbes can fluctuate a lot from year to year. Apple’s valuation has changed by 17% in one year! If Apple tracked this in their Balance Sheet, they would need to make dramatic shifts in their equity from year to year as the value of their brand changed, and that doesn’t provide for very accurate or comparable accounting statements. Secondly, Forbes has nothing to lose by being wrong. If they’re off by a few billion dollars in brand valuation, it isn’t going to hurt the bottom line of Forbes. 

For this reason, valuations of brands are not counted in the balance sheet. However, if a company is acquired, the acquiring company may pay a considerable amount more than the accounting book value of the company, in part to purchase a valuable brand. In this case, the value will not change year-to-year, and the bottom line of the acquiring company will be hurt if they are wrong – so we can be reasonably certain that the value is correct. Now that there’s certainty to the value, this value can be tracked on the balance sheet, as part of the entry known as “goodwill” – a sort of catch-all account for all value that an acquisition holds above and beyond its basic book value (of which brands may only be one part).

Visit Forbes to see more powerful brands: http://www.forbes.com/powerful-brands/list/