Why Does a Balance Sheet Need to Balance?
The balance sheet is packed with financial information crucial to understanding the health of your company.
However, for a lot of people, it’s one of the hardest financial statements to get to grips with.
Even the most fundamental pillar of the balance sheet, why it needs to balance, eludes many of us.
It’s easy to look up the formula Assets = Liabilities + Equity but not so easy to understand why this formula is the way it is.
It’s actually a lot simpler than you think. Let’s take a look.
What does a balance sheet consist of?
The balance sheet is split into two halves. Each half, on its own, should add up to the total value in the business.
The top half (Assets) breaks down how this value is being used in the business.
The bottom half (Liabilities + Equity) breaks down how this value was acquired i.e. the sources of funding.
The two halves must balance because the total value of the business’s Assets will ALL have been funded through Liabilities and Equity.
If they aren’t balancing, it can only mean that something has been missed or an error has been made. More on that later!
For now, let’s put this into a simple example:
Let’s say you have £10,000 sitting in your bank account.
This is classed as an asset so sits on the top half.
Over on the bottom half, we have two activities going on. We have a loan that we need to pay back of £5,000 and retained profit (money earned by the business in a previous period) of £5,000.
In this simple example, there is £10,000 sitting in our bank account because we took out a loan of £5,000 and collected £5,000 worth of profit last month.
So the top is describing where the value in the business is (my bank account), and the bottom half is showing where it came from (a loan and my past profits).
It balances because the top half and the bottom are looking at the same money.
This isn’t very obvious if you are looking at a more full balance sheet. The value of most businesses won’t just be sitting in a bank account. It’ll be split across a variety of places.
Likewise, the bottom half can become more complex too. With more going on it becomes far harder to see how the two halves relate to each other at a glance.
It all works due to a process that accountants refer to as ‘double-entry accounting’.
This process means that every time a single transaction occurs it will be recorded in at least two places.
Similar to our example above, if an additional £5,000 is recorded in our bank account then this must be ‘balanced’ by a record on the bottom half showing where it came from (from making sales, borrowing money or receiving investment for example).
With both records always being entered at the same time, the balance sheet should always balance.
Let’s go into more detail about how the two halves work.
The Top Half – Assets (What the company owns)
The top half marks down everything that could contribute to the value of the business.
It ranges from cash in your bank account to the value of equipment you own. These are your assets.
You’ll even see the value of money owed to you but not yet received (accounts receivable). This still counts as an asset even though you haven’t received the cash just yet.
For a full breakdown of the balance sheet categories check out our beginners guide to the balance sheet article.
Remember we said that the balance sheet has to balance as each half is looking at the exact same value. Like two sides of the same coin.
Well, on the top half, that value is simply the complete worth of everything in the business. What we are doing here is breaking down where that value is in your business.
Now, the bottom half is going to tackle this same number but instead break it down by how this value got there. How were all of these Assets funded?
Let’s take a look.
The Bottom Half – Liabilities and Equity (What the company owes)
Essentially, the bottom half maps out how the company acquired its value. It shows the methods that were used to pay for your assets in the top half.
The bottom half is split into two major categories: liabilities and equity.
Liabilities represent types of money that your business owes.
It takes all forms of debt into consideration such as outstanding loans or tax payments.
Similarly to having accounts receivable in the top half, you also see the money you owe to others (accounts payable) in the bottom.
Equity consists of any profit made from previous periods and any money invested into the business by a shareholder.
The combination of liabilities and equity gives you the total monetary value put into the business. All of this will have been ‘used’ in the top half in the form of assets.
So it should be impossible for the balance sheet to ever be unbalanced.
But sometimes it doesn’t balance! Which means something must have gone horribly wrong…
What Could Cause a Balance Sheet Not to Balance?
For a balance sheet not to balance, there must be an error somewhere in the report. This can either be human or a software error:
- Entering figures in one half and forgetting about the other half
- Entering a figure into the wrong account
- Mistyping a figure
- Inputting a negative where it should be a positive
- Software rounding errors
- Data corrupting
- Pulling data from incorrect sources
Looking at the two halves of the balance sheet is like looking at two sides of the same coin.
Remember, the top half and the bottom half of the balance sheet break down the same figure. The total value of the business.
It should always balance because every individual transaction impacts both sides. Where the money came from and what it’s being used for.
So, if the double-entry accounting process has been followed correctly, it’ll always be the same.
If your balance sheet isn’t balancing then the only explanation is that an error of some kind has crept in along the way.
Understanding this fundamental pillar of the balance sheet should make it a bit easier to analyse this key report.
Now, was that so hard really? 🙂