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The balance sheet always balances

Assets = liabilities + equity, and why every transaction keeps it true.

FinanceReading the accountsAbout 5 min: 2 reading, 3 practiceUpdated

General education, not financial advice.

After this lesson you can
  • Sort items into assets, liabilities and equity
  • Use assets = liabilities + equity
  • Record a transaction in two places

Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.

The Intelligent Investor: Benjamin Graham's ideas: lesson 9 of 25
  1. Graham ch. 1
  2. Investment versus speculation 4 min
  3. Graham ch. 2
  4. Inflation and the investor 4 min
  5. Graham ch. 3
  6. A century of market history 5 min
  7. Graham ch. 4
  8. The defensive investor's portfolio 4 min
  9. Graham ch. 8
  10. Mr. Market 5 min
  11. Living with fluctuations 5 min
  12. Graham ch. 9
  13. Investing in funds 5 min
  14. Costs and the market
  15. Is advice worth paying for? 7 min
  16. Reading the accounts
  17. The balance sheet always balances 5 min
  18. Graham ch. 5
  19. Defensive investors and stocks 4 min
  20. Graham ch. 6
  21. What the enterprising investor avoids 4 min
  22. Graham ch. 11
  23. Security analysis for the lay investor 4 min
  24. Graham ch. 12
  25. Per-share earnings and their traps 4 min
  26. Graham ch. 7
  27. What the enterprising investor does 5 min
  28. Graham ch. 13
  29. Comparing four companies 4 min
  30. Graham ch. 14
  31. The defensive investor's screen 4 min
  32. Graham ch. 15
  33. The enterprising investor's screen 7 min
  34. Graham ch. 16
  35. Convertibles and warrants 6 min
  36. Graham ch. 17
  37. Four extreme case histories 7 min
  38. Graham ch. 18
  39. Eight pairs of companies 7 min
  40. Graham ch. 19
  41. Shareholders, managements and dividends 5 min
  42. Graham ch. 20
  43. Margin of safety (1): the idea 5 min
  44. Margin of safety (2): in practice 7 min
  45. Graham appendix 1
  46. The superinvestors of Graham-and-Doddsville 6 min
  47. Graham postscript
  48. Graham today 7 min

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Pairs with any introduction to financial accounting, such as the ACCA FA1 study notes or the Corporate Finance Institute's Accounting Fundamentals, module 1

What it is

A balance sheet is a snapshot of what a business owns and how it paid for it, on one date.

  • Assets: what the business owns or controls, like cash, stock waiting to be sold, and equipment.
  • Liabilities: what it owes others, like a bank loan or unpaid bills to suppliers.
  • Equity: what belongs to the owners: money they put in, plus profits kept in the business.

Every asset was paid for either by borrowing or by the owners, so:

assets = liabilities + equity

Quick check

Tap an answer to check it.

  1. Money the business owes the bank is…

    Show answer

    a liability. Anything the business owes is a liability.

Why it matters

This equation is the base of all accounting. Every transaction is recorded in two places so the two sides stay equal. If a balance sheet does not balance, something has been recorded wrongly.

Worked example

A small bakery starts up. Watch both sides after each step.

StepAssetsLiabilities + equity
Owner puts in 500 cashCash 500Equity 500
Borrows 300 from a bankCash 800Loan 300 + equity 500 = 800
Buys an oven for 400 cashCash 400 + oven 400 = 800800 (no change)
Sells bread for 150 that cost 50 in flour (bought with cash)Cash 500 + oven 400 = 900Loan 300 + equity 600 = 900

Buying the oven only swaps one asset for another. The sale adds a profit of 100, which belongs to the owner, so equity rises by 100 and the sheet still balances.

The bakery's balance sheet after the saleTwo columns of equal height. Left: assets 900. Right: liabilities 300 with equity 600 on top, together 900. The two sides balance.Assets900=Liabilities300Equity600What it ownsHow it was paid for
The bakery's balance sheet after the sale
Text description

Two columns of equal height. Left: assets 900. Right: liabilities 300 with equity 600 on top, together 900. The two sides balance.

Buying an oven for 400 cash is recorded in two placesBuy an oven for 400 cash is recorded twice. One entry: Oven (asset) , goes up by 400. The other: Cash (asset) , goes down by 400.Buy an oven for 400 cashOven (asset)goes up by 400Cash (asset)goes down by 400
Buying an oven for 400 cash is recorded in two places
Text description

Buy an oven for 400 cash is recorded twice. One entry: Oven (asset) , goes up by 400. The other: Cash (asset) , goes down by 400.

Common mistake

Treating profit as cash. Profit raises equity; it does not always mean more cash. A sale on credit, for example, raises profit while the money is still owed by the customer.

Key terms

assets
what a business owns or controls
liabilities
what it owes others
equity
what belongs to the owners: money put in plus profits kept
balance sheet
a snapshot, on one date, of assets, liabilities and equity
statement of financial position
the name used in international accounting standards (and by ACCA) for the balance sheet
capital
another name for the owner's equity, used especially for small businesses; profit adds to it and drawings reduce it
drawings
money or goods the owner takes out of the business for personal use
current and non-current
assets and liabilities are split by whether they turn into cash, or fall due, within about a year

Practise the key terms

Tap a card to turn it over. 8 cards.

FrontBack
assetswhat a business owns or controls
liabilitieswhat it owes others
equitywhat belongs to the owners: money put in plus profits kept
balance sheeta snapshot, on one date, of assets, liabilities and equity
statement of financial positionthe name used in international accounting standards (and by ACCA) for the balance sheet
capitalanother name for the owner's equity, used especially for small businesses; profit adds to it and drawings reduce it
drawingsmoney or goods the owner takes out of the business for personal use
current and non-currentassets and liabilities are split by whether they turn into cash, or fall due, within about a year

Practice

Quick quiz

Tap an answer to check it.

  1. A business buys a van for 2,000 cash. What happens to total assets?

    Show answer

    They stay the same. Cash falls by 2,000 and vehicles rise by 2,000.

  2. A business borrows 1,000 from a bank. Which two things rise?

    Show answer

    Cash and liabilities. The cash is an asset; the loan is owed, so it is a liability.

Spot the error

One line is wrong. Tap it.

  1. A small shop's balance sheet. The bank has confirmed the loan is 700. Which line is wrong?

    Show answer

    Owner's equity 1,400. 700 + 1,400 = 2,100, not 2,000. For the sheet to balance, equity must be 1,300.

Practice problems

Basic

  1. A business has assets of 9,000 and liabilities of 3,500. What is its equity?

    Answer and full solution

    Answer: 5,500

    1. Equity = assets − liabilities = 9,000 − 3,500 = 5,500.

Intermediate

  1. A shop buys 400 of stock on credit (to pay the supplier later). What changes on the balance sheet?

    Answer and full solution

    Answer: Inventory (an asset) rises by 400 and money owed to suppliers (a liability) rises by 400.

    1. The shop now owns more stock: assets +400.
    2. It has not paid yet, so it owes the supplier: liabilities +400.
    3. Both sides rise by 400, so the sheet still balances.

Challenge

  1. An owner starts with 1,000 cash, borrows 500, buys equipment for 600 cash, buys stock for 200 cash, then sells all the stock for 350 cash. Write the final balance sheet.

    Answer and full solution

    Answer: Cash 1,050 + equipment 600 = assets 1,650; loan 500 + equity 1,150 = 1,650.

    1. Cash: 1,000 + 500 − 600 − 200 + 350 = 1,050.
    2. Equipment 600; stock 200 bought then sold, so 0.
    3. Profit on the sale: 350 − 200 = 150, so equity = 1,000 + 150 = 1,150.
    4. Liabilities: the loan, 500. Check: 500 + 1,150 = 1,650 = 1,050 + 600.

In short

  • Assets = liabilities + equity, always.
  • Every transaction changes two things, so the sheet still balances.
  • Swapping one asset for another leaves totals unchanged.
  • Profit raises equity; it is not the same as cash.

Mastery check

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Check yourself

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  1. Write the balance sheet equation.

    Show answer

    Assets = liabilities + equity.

  2. Is a bank loan an asset, a liability or equity?

    Show answer

    A liability, because the business owes it.

  3. Assets are 10,000 and liabilities are 6,000. What is equity?

    Show answer

    4,000.

Further reading

  • Corporate Finance Institute, Accounting Fundamentals course notes, Module 1.
  • OpenStax, Principles of Accounting, Volume 1: Financial Accounting (2019), free online at openstax.org.