In this content, we’re going to discuss at this question is why do we start with a balance sheet? when we’re trying to gain insight into the performance of a business? To answer that question, we first need to think about financial health of a business. The balance sheet shows us, the assets that the firm owns or controls and I’ll come to that control issue in a later topic. What assets the business owns, and how are those assets financed? Where did the money come from in order to finance them? It may be the case that the funds came from outsiders, such as banks. So the business borrowed money to acquire the assets or the owners putting the money to finance the assets, or some combination.
The Financial Health of a business
What the balance sheet shows us. We have the assets. and these are things that provide the business with future benefits. So the definition of an asset is a resource that provides future benefits. They must be benefits that we can measure. We must be able to identify them. We must expect them to occur with reasonable certainty. Those assets, we said, could be financed by one of two major sources. The first is banks, or perhaps suppliers.
They present future obligations for the business. If we borrow money from the banks, clearly we’ll have to pay that bank at one stage. If our suppliers give us credit, eventually we’ll have to meet our obligations to our suppliers. Supporting that is the equity of the business. The equity are the funds that the owners contributed to the business to enable us to buy the assets. Let’s take a look at the figures for a well-known supermarket business, Woolworth’s. These are recent figures. Woolworth’s had $22 billion in assets on its balance sheet, largely property, fittings, stock. Think about a supermarket. Where did it get the money to acquire such a large amount of assets? Well, outsiders such as banks provided $13 billion worth of that financing. The rest is coming from the owners, $9 billion financing.
So that’s what the balance sheet looks like for a business such as Woolworth’s. Another way to think about this is, this is what the business owns, its assets, and this is what the business owes, its liabilities or its future obligations. So, equity is the difference between what the business owns and what the business owes? So, why do we start with a balance sheet, when we’re attempting to assess the financial health of a business? The reason is we start with a balance sheet because we cannot generate any income or revenue unless we have assets. Everything starts with the assets. If it’s a mining company, it needs equipment and a mining licence. The licence can be recorded as an asset on the balance sheet of that business.
The supermarket, I just said, it needs property and it needs fittings and it needs stock. The airline requires aircraft. A retail business requires stores and stock. A consultant requires a computer, at least, and brand, although brand is not something. We can put on the balance sheet, we’ll see, unless we actually buy it because that can be measured. The second reason that we start with a balance sheet is virtually every activity that a business engages in flows through its balance sheet in some way. It buys assets. It raises funds to buy assets. It repays funds. The owners contribute funds. All of those things flow through the balance sheet. It also, when the business generates income by selling products or selling services, there’s a balance sheet impact. It gets cash, it’s on the balance sheet in the form of assets.
If the firm doesn’t get cash yet, it’s on the balance sheet in an item called receivables. If a firm pays wages to its staff, an expense, it goes through the balance sheet because cash is affected. The cash is an asset on the balance sheet.