Financial Analysis Using Common-size Income Statements

The balance sheet is also known as the statement of financial position or statement of financial condition. It is a financial statement that gives a snapshot of a company’s assets, and its sources of capital, i.e., liabilities and shareholder’s equity, at a specific point in time. This provides vital information on what a company owns, what it owes, and what its owners’ claims are.

Elements of the Balance Sheet

The three basic elements of the balance sheet are assets, liabilities, and equity.

• Assets refer to the resources which a company owns or controls because of past events and from which future economic benefits are expected to flow.

• Liabilities refer to anything which the company owes. These obligations occur because of past events and their settlement is expected to result in an outflow of economic benefits.

• Equity or shareholders’ equity refers to the owners’ residual interest in the company’s assets after the deduction of its liabilities.

The three basic elements may be represented in the form of the basic accounting equation:

$$ \text{Assets} = \text{Liabilities} + \text{Equity} $$

Question 1

Which of the following statements is correct?

B. Equity is equal to Assets less Liabilities.

A. Equity refers to the resources of a company.

C. Liabilities refer to things which a company owns.

Solution

The correct answer is A.

Rearranging the basic accounting equation, ‘Assets = Liabilities + Equity’, and making ‘Equity’ the subject, we see that ‘Equity = Assets – Liabilities’.

B is incorrect because ‘Assets’, and not ‘Equity’, refer to the resources of a company.

C is incorrect because ‘Assets’, and not ‘Liabilities’, refer to things which a company owns.

Question 2

ABC Company reported a total assets value of $250,000 and a total equity value of $100,000. What is the value of the company’s liabilities?

1. $150,000
2. $175,000
3. $350,000

Solution

The correct answer is A.

As a company’s assets could be calculated as the sum of its liabilities and its equity:

$$ \text{Assets} = \text{Liabilities} + \text{Equity} $$

Hence, the value of a company’s liabilities is the result of deducting that company’s equity from its liabilities.

L = A – E = $250,000 – $100,000 = $150,000