are amounts of money that a company owes to others.
This can include all kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of
a building, money owed to suppliers for materials, payroll a company owes to its employees, environmental cleanup
costs, or taxes owed to the government. Liabilities also include obligations to provide goods or services to
customers in the future.
equity is sometimes 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
The following formula summarizes what a balance sheet shows:
LIABILITIES + SHAREHOLDERS' EQUITY
assets have to equal, or "balance," the sum of its liabilities and shareholders' equity.
A company’s balance sheet is set
up like the basic accounting equation shown above. On the left side of the balance sheet, companies list their
assets. On the right side, they list their liabilities and shareholders’ equity. Sometimes balance sheets show
assets at the top, followed by liabilities, with shareholders’ equity at the bottom.
Assets are generally listed based
on how quickly they will be converted into cash. Current assets are things a company expects to convert to
cash within one year. A good example is inventory. Most companies expect to sell their inventory for cash within
one year. Noncurrent assets are things a company does not expect to convert to cash within one year or that
would take longer than one year to sell. Noncurrent assets include fixed assets. Fixed assets are
those assets used to operate the business but that are not available for sale, such as trucks, office furniture and
Liabilities are generally listed
based on their due dates. Liabilities are said to be either current or long-term. Current
liabilities are obligations a company expects to pay off within the year. Long-term liabilities are
obligations due more than one year away.
Shareholders’ equity is the
amount owners invested in the company’s stock plus or minus the company’s earnings or losses since inception.
Sometimes companies distribute earnings, instead of retaining them. These distributions are called dividends.
A balance sheet shows a snapshot
of a company’s assets, liabilities and shareholders’ equity at the end of the reporting period. It does not show
the flows into and out of the accounts during the period.
An income statement is a report
that shows how much revenue a company earned over a specific time period (usually for a year or some portion of a
year). An income statement also shows the costs and expenses associated with earning that revenue. The literal
“bottom line” of the statement usually shows the company’s net earnings or losses. This tells you how much the
company earned or lost over the period.
Income statements also report
earnings per share (or “EPS”). This calculation tells you how much money shareholders would receive if the company
decided to distribute all of the net earnings for the period. (Companies almost never distribute all of their
earnings. Usually they reinvest them in the business.)
To understand how income
statements are set up, think of them as a set of stairs. You start at the top with the total amount of sales made
during the accounting period. Then you go down, one step at a time. At each step, you make a deduction for certain
costs or other operating expenses associated with earning the revenue. At the bottom of the stairs, after deducting
all of the expenses, you learn how much the company actually earned or lost during the accounting period. People
often call this “the bottom line.”
At the top of the income
statement is the total amount of money brought in from sales of products or services. This top line is often
referred to as gross revenues or sales. It’s called “gross” because expenses have not been deducted from it yet. So
the number is “gross” or unrefined.
The next line is money the
company doesn’t expect to collect on certain sales. This could be due, for example, to sales discounts or
When you subtract the returns and
allowances from the gross revenues, you arrive at the company’s net revenues. It’s called “net” because, if you can
imagine a net, these revenues are left in the net after the deductions for returns and allowances have come out.
Moving down the stairs from the
net revenue line, there are several lines that represent various kinds of operating expenses. Although these lines
can be reported in various orders, the next line after net revenues typically shows the costs of the sales. This
number tells you the amount of money the company spent to produce the goods or services it sold during the
The next line subtracts the costs
of sales from the net revenues to arrive at a subtotal called “gross profit” or sometimes “gross margin.” It’s
considered “gross” because there are certain expenses that haven’t been deducted from it yet.