At the beginning was the Equity

30 Jan 2023

With this post, I am concluding the analysis of the company's balance sheet. You can read the previous parts here:
Part 1 - Balance sheet: taking the first steps
Part 2 - Assets I prioritize
Part 3 - A sense of debt

Now we know that every company has assets on one side of the balance sheet and liabilities and equity on the other side. If you add liabilities and equity together you get the sum of assets. And vice versa, if you subtract all of the company's liabilities from the assets, you get what? That's right, you get Equity. Let's discuss this important component of the balance sheet.

When a company is first established, it must have initial equity. This is the money with which any business starts. It is used for the first expenses of the new company. In the case of our workshop, the equity was the master's savings, with which he bought the garage, equipment, raw materials and other assets to start his business. As sales progressed, the workshop received the revenue and reimbursed expenses. Whatever was left over was used to boost the company's profit. So, our master invested his capital in the business to increase it through profits.

Making a profit is the main purpose for which the company's assets work, loans are raised, and equity is invested.

Let's see which balance sheet items are in the Equity group:
- Common stock (The sum of nominal values of common stock issued). Remember, when our master decided to turn his company into a stock company, he issued 1 million shares at a price of $1,000 per share. So $1,000 per share is the par value of the stock. And the sum of the nominal values of the stocks issued would be $1 billion.
- Retained earnings. It is clear from the name of this item that it contains profits that have not been distributed. We will find out where it can be allocated in the next post, when we start analyzing the income statement.
- Accumulated other comprehensive income (Profit or loss on open investments). The profit or loss of a company can be not only from its core business, but also, for example, from the rise or fall in the value of other companies' shares that it bought. In our example, the workshop has oil company shares. The financial result from the revaluation of these shares is recorded in this item.

So, the equity is necessary for the company to invest it in the business and make a profit. Then the retained earnings themselves become equity, which is reinvested to make even more profits. It's a continuous cycle of the company's life that bets on equity growth.

Which balance sheet items are of interest to me in the Equity group? Of course, I am interested in the profit-related items: retained earnings and profit or loss on open investments. The sum of nominal share values is a static indicator, so it can hardly tell us anything.

However, it is better to use information from the income statement rather than the balance sheet to analyze earnings, because only this report allows us to see the entire structure of a company's income and expenses.

So we conclude the general analysis of a company's balance sheet. To fully understand why it is needed, let's engage our imagination once again. Do you remember the example with the hotel? We imagined that a joint stock company is a hotel with identical rooms, where you, as an investor, can buy a certain number of rooms (one room = one share). Think about what you would want to look at first before buying? Personally, I'd rather see photos of the rooms.

So, the balance sheet can be compared to such photos that we get from the hotel at quarterly and annual intervals. Of course, in such a case, the hotel will try to use special effects as much as possible in order to improve investors' impression of the photos released. However, if we track and compare photos over multiple periods, we can still understand: is our hotel evolving, or have we been watching the same couch in a standard room for 10 years in a row.

We can say that the balance sheet is a "photo" of the company's assets, debts and equity at the balance sheet date. And the balance sheet items I've chosen are what I look at first in this photo.

In the next series of posts, we will break down an equally important report, the income statement, and explore the essence of earnings. See you soon!