The shareholders put money into a company to do business. How much is the money that shareholders put into a company?
- Money that they actually invested as equity
- Money that they actually invested as premium
- Money that they DID NOT TAKE AWAY as dividend – aka the profits left in the business
What is all this money used for?
- buying assets
- using as a margin of safety to borrow money
- funding working capital
this is called “equity”, or “shareholders Funds” or “shareholder’s equity”. If there are no preference shares, the equity shareholders funds = Assets MINUS Outsider’s liabilities.
The following formula summarizes what a balance sheet shows:
ASSETS = OUTSIDER’S LIABILITIES + SHAREHOLDERS’ EQUITY
A company’s assets have to equal, or “balance,” the sum of its liabilities and shareholders’ equity. Shareholders’ equity is the amount owners invested in the company’s shares plus or minus the company’s earnings or losses since inception. Sometimes companies keep the earnings to improve the strength of their balance sheet – these are called reserves. Sometimes the earnings are distributed , instead of retaining them. These distributions are called dividends.
Share holder’s equity is also called capital or net worth. It’s the money that would be left if a company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company. Hence equity is also called “residual amount“.
This is also called “Margin of safety” for the outsiders who lend money to the company.
Also called “risk capital” – because in case the assets sold is not enough to cover the liabilities, it is these guys who take the ‘hair cut’.
also called “capital adequacy” when this number is arrived at for banks and insurance companies. Here we are asking “is the capital adequate to take the losses if the quality of assets falls or there are more claims than what the underwriter expected”.
A company’s balance sheet is created like the basic accounting equation shown above. On one side of the balance sheet, companies list their assets. On the other side, they list their liabilities and shareholders’ equity. (Horizontal form)
Sometimes balance sheets show assets at the top, followed by liabilities, with shareholders’ equity at the bottom. (Vertical format)
Assets are generally listed based on how quickly they will be converted into cash. The most illiquid asset like land or plant and machinery are called ‘Fixed Assets’ and are shown on the top of the balance sheet.
Assets are things a company expects to convert to cash within one year are called Current Assets. Good examples are inventory, debtors, cash, etc. Companies expect to sell their inventory for cash within one year. In fact they are called ‘current’ because they keep changing form regularly. ‘Currently they are in the form of inventory, they will soon change to debtors or cash’ – is what we mean actually, hence the word ‘current’.
Assets which are things a company does not expect to convert to cash within one year or that would take longer than one year to sell. In fact there is no intention to change the ‘form’ of these fixed assets or non-current assets. These assets are those assets used to operate the business but that are not (normally) available for sale, such as factories, cars, trucks, office furniture and other property.
Liabilities are generally listed based on the dates on which they are to be paid i.e. their due dates. Liabilities are said to be either short-term (due within a year) and Long-term -those that are obligations due more than one year away.
A balance sheet is a snapshot of a company’s assets, liabilities and shareholders’ equity ON A PARTICULAR DAY, normally at the end of the reporting period.
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