What to look for in a balance sheet

- Let's talk about the balance sheet in a little bit more detail. The balance sheet is built around one of the most awesome creations of the human mind, the accounting equation. Assets equal liabilities plus equity. The great insight behind the accounting equation is this. Every time we get an asset, let's write down where we got the money to buy that asset. So we've got the two sides of the accounting equation. The first side, the asset side, that's the real world. You can go touch a company's assets, it's cash, it's buildings, it's land. That's the real part of a company. The other half of the accounting equation just says where you got the money to buy those assets. So what are assets? A formal definition is that assets are resources owned or controlled by a company that will provide probable future benefit. Let's take a simple example, the balance sheet of Walmart. As of January 31st, 2023, the balance sheet of Walmart says that the company has nine billion dollars in cash. Is that a resource that will provide probable future benefit? I say yes. Cash is a good asset. Inventory. That's the stuff on the Walmart shelves that you can buy from Walmart. On January 31st, 2023, Walmart had inventory costing $57 billion dollars. Inventory is an asset. Walmart's land, $19 billion dollars. Walmart's buildings, $105 billion dollars. Trucks, $2.5 billion with additional assets such as the shelves and freezers in Walmart stores. As of January 31st, 2023, the total amount reported for all of the assets in Walmart's balance sheet, $243 billion dollars. Now for United Airlines, important assets are the airplanes. For Disney, important assets are the theme parks. Now, the other side of Walmart's balance sheet outlines where Walmart got the money to buy the $243 billion dollars in assets. First are the liabilities, the amounts that Walmart used to buy assets but will have to repay in the future. As of January 31st, 2023, Walmart reported about $60 billion dollars in loans. Loans are a good source of money to buy assets. Walmart also reported $54 billion dollars in something called accounts payable. Now, when Walmart buys inventory, the company promises its suppliers, Proctor and Gamble, or Black and Decker, or whomever, that they will pay in the future. That's a liability, an obligation to pay in the future. The insight of the accounting equation is that you've got to write down the asset, the inventory in this case, and you also write down how you bought the asset. In this case, you promised to pay later. Accounts payable is a good example of a liability. Another way to get money to buy assets is from the business owners. In this case, the source of the financing is called equity. Owners can invest directly in a business. We call those amounts paid-in capital or contributed capital, or in the case of a corporation, common stock. Another way that owners invest in a business is through retained profits. When a business generates a profit, the owners own those profits. The owner can choose to take some of those profits out of the business for personal use. We call those distributed profits dividends. In contrast, more often than not, owners will decide to put most of the profits back in the business for expansion. If the profits are kept in the business, then the label we give to that source of equity is retained earnings. The sum of two things, paid-in capital and retained earnings is called equity. Liabilities and equity are the labels for the two general sources of financing to buy assets. So where did Walmart get the $243 billion dollars it needed to buy its assets? Well, a lot of it came from retained earnings, $83 billion dollars worth. Some of it came from loans. Quite a bit of it came from accounts payable. We call this financial statement a balance sheet for a reason. It balances. It has to balance. By definition, if you buy assets, then you have to get the money to buy those assets from somewhere. The accounting equation always holds. Always.