BUSI 170 - Financial Analysis for Leaders (Section 3.1)
August 20, 2026
I think the business world divides into two types of people.
There are those who do, and they are judged on execution and performance. The question in front of them is this. Here is what we want to do. We are in business, so we want to do this behavior, and we think this behavior is going to produce more revenues than the cost it produces. So go out and do that. We want to know whether you can do that well, and you are judged on that performance. You are a producer, and we see that in the income statement.
There is another group of people who have to make a different decision. Of all the things that we could do, how should we deploy our resources and people and talent against these opportunities? How do we make those choices? These people are not so much operational executors. They are decision makers, resource allocators. Those people are typically higher up, because you are making the decision - can you execute, but where should we be executing in the first place?
They are judged on something different instead of performance. They are judged on return on investment. We take that performance and we ask: okay, so you did this right, let’s imagine that’s good. What did you invest? What did it take in dedicated resources to earn that? It is not enough that you have a great impact. The question is, what resources did we employ to capture that impact? Now I am judging you on how good that ratio is - how good is that return on investment.
The balance sheet is what helps us understand this. That is why we talk about it here. The income statement is our performance: how much did we get, and how much did we have to spend to get it. That gives you a quantification of value created, by profit. But then the question is, what did we have to invest? What did we have to put at stake, put down money we had to get from investors, or invest our own money, in order to get that profit? That is a measure of performance as well. Return on investment is the ultimate measure of value creation in a financial sense.
If you look at the income statement, you are going to think: isn’t that enough? Why do we need another statement like the balance sheet?
The income statement tells you how we performed - how much customers gave us, minus what we had to pay to get that revenue, and the difference is profits. That is how we keep score. But the question is: what did we have to invest? How much did the business have to have in order to create that value we see on the income statement?
That is what a balance sheet is. It has all the assets, which are all the resources the business has to create the value we see on the income statement. And on the right side, it says who owns it. Liabilities are the people we owe money to, the creditors. We have to pay them off first, and whatever is left - assets minus liabilities - is owner’s equity. That is the stuff the owners own.
So the balance sheet, on the left side, tells you all the stuff a business has control over, the resources it uses to create that performance. The right side tells you who has claims: whether it is creditors, or the residual amount after you subtract what you owe, which is what the owners own.
For resource allocators, we want to know not only how much performance a business has created, but what they had to put at stake. How many resources did they have to invest in order to capture that performance? That is why we need the balance sheet.
Suppose someone hands you a balance sheet and an income statement and tells you that you can only keep one. Which one do you keep?
If I want to talk about performance in a business, I keep the income statement, because what you are looking for there is that it tells you more about the economics of a business. What does it do to create value? If that is the question you want, the income statement is the one you want. The balance sheet is an inventory, a list of all the things the business has to create value in the first place. It is a static picture. It does not tell you how performance is. It tells you a state of what it’s got. So if I had to pick one, it’d be the income statement.
I say this at the front of a chapter about the balance sheet on purpose. The balance sheet is not a better statement than the income statement. It answers a question the income statement cannot answer, and the question only becomes urgent once you start caring about return rather than result. Keep that in mind for everything that follows.
The balance sheet has two sides.
A note on how it gets drawn, because it varies and the variation confuses people. We group the assets on the left or on top, and the liabilities and owner’s equity on the right side or the bottom. Both layouts are common and both carry the same data. Side by side lines up with the accounting equation, with the left of the equation on the left of the page. Stacked is what you will meet more often in print, including in this book, because it fits a page better. So when the text says left side and right side, read it as top and bottom if that is the layout in front of you.
On the left side, all the assets. That is all the stuff, all the resources that a business has to create value.
On the right side we ask who owns it. These are the claims. In the simplest case, we don’t owe anybody anything, and all these resources are owned by the owner. We have $10,000 of assets, and the owners have a claim on the whole business.
If you have taken on debt, then the first thing is that those people have to be paid first. You take everything you’ve got, and you subtract what you owe those other people, and whatever is left is what the owners have.
That ordering matters more than it looks. The creditors are not just another claimant; they are a claimant who gets paid before you do, whether or not the year went well. When an owner takes on a liability, the cost is not only the interest. It is that a fixed claim now sits ahead of the owner’s residual one.
The fundamental accounting equation is:
\[\text{Assets} = \text{Liabilities} + \text{Owner's Equity}\]
This always has to balance. It is the fundamental structure of the balance sheet, and this identity is always true no matter what happens to the business. It would pay to have that equation written out, and then to see that it is the genesis, the origin, of what a balance sheet looks like.
Another way of doing this, by algebra, is to rearrange it:
\[\text{Owner's Equity} = \text{Assets} - \text{Liabilities}\]
Everything we’ve got, minus what we owe, is what the owners own.
That is simple algebra, but there is some intuition there. All the stuff you’ve got to run the business, which is assets, minus all the stuff you owe, is the part of the business the owners have a claim to. If we were to liquidate this business and sell all of our assets - and let’s say our assets are worth the value we have on our balance sheet - and then we had to pay off all of our debts for the liabilities, what we’d have left is what we have in the business. That is the residual value the owners have, and that is what owner’s equity is.
The two forms are not the same sentence rearranged. The first form says: here is what the business has, and here is the complete list of people with a claim on it. The second says: here is what is left for you after everyone ahead of you is paid. The first is a description of structure. The second is a statement about your position in a line.
The accounting equation always balances. Students hear that and think it is a deep truth. It is closer to an operating definition, an identity.
And just because it balances doesn’t mean it’s right. There are ways to have the accounting equation in balance and still be wrong. For example, if the assets total is right but it’s misallocated - cash is too high, inventory is too low - that is still an error, and it won’t show up, even though the account balances.
Or suppose we don’t recognize an unearned revenue that we were supposed to recognize. What we’re going to have is that the liability is going to be too big and the owner’s equity is going to be too small. Even though the sum of them is still going to add up to the correct number and balance out to the assets on the left side, it’s still not right.
Think of it as a necessary but not sufficient condition. A balance sheet that balances tells you the books are capable of being in order. It does not tell you that they are.
We have to split up equity into what owners put in and what the business generated for the owners. We like to keep those things separate.
Paid-in capital is what owners of the business put into the business to make it run. It’s like a blood transfusion. We put in this value to give the business some assets, and that was our initial putting-in so the thing could run. As the business runs we might put in some more. These are things the business didn’t earn money with - the owners put it in to support it.
The business didn’t create that value. They didn’t sell anything and then generate profits, and those profits are created value. When we put money into a business, the business didn’t create value. We put that in and it goes into owner’s equity, and now they have assets to work with and create the business, but they haven’t created any value yet. You don’t create value until you actually do something - create a good or product, sell it to a customer, and that customer gives you money, and that money is more than the cost to produce. That’s profit, and that is value the business created, still owned by the owners.
Retained earnings are the accumulation of all the previous times this business has earned money and had positive profits. That stuff, if it doesn’t get paid out, flows back into the business. This is all the money the business has generated for itself that the owner has claims to. If you run this business a couple of times, you make profits year on year and keep it in the business, and that will accumulate in retained earnings.
So we’d like to have two going accounts in owner’s equity:
Some people have the analogy of going to a casino. You go in with, say, $100. You start going to tables and then you realize, hey, I’ve earned some money here - I made $50 at a blackjack table. A lot of people say, I’m going to put this $100 away, that’s what I walked in with. I have $50 left and now I’m playing with house money.
This is the stuff that I earned while I was here, and I could feel free to use this money, because as long as I gamble, even if I lose it all, that’s money I didn’t walk in here with. I always preserve my initial investment, so to speak, in this gaming.
Think about paid-in capital as your money, and retained earnings as the money you earned while you were in the casino - the house money. That is the value generated from the business itself, not what you had to put into it to get it going. We like to separate out the house money from what we had to put in.
The distinction is not bookkeeping fussiness. It is the difference between value that was contributed and value that was created, and only one of those is evidence that the business works.
The balance sheet is a snapshot in time. This is what the business has at this given moment. The income statement is a flow. It tells you what the performance has been over a period. There is always a start date and an end date on an income statement. It’s often a year, because we like to think about how much a business does per month in a year, but it could also be a quarter or a month or any arbitrary time.
The important part is that it’s over a period of time. When we talk about needing resources in order to produce performance, after the performance has been created and we have this net profit, what happens? The next period comes and we wipe the whole scoreboard clean, and the income statement is going to start all over again.
We take that profit and add it to retained earnings. Why? Because the business has now created this value. We see it in the net profit, and if they don’t pay it out, it is value that business created and it’s parked in owner’s equity, under retained earnings.
We move that number from the income statement over to the balance sheet. Now we’ve got this retained earnings in there, and then the income statement is wiped clean and it starts once again at the beginning of a new period, accumulating revenues minus cost equals profits. If there are more profits in the next year, that also will get closed off to the balance sheet, to retained earnings.
Eventually the income statement comes back to talk to the balance sheet. That is the connection between the two statements, and it runs through exactly one line: retained earnings.
Now, if you’re going to grow this business - if you see this performance and you want to get more performance, you want to be bigger - you’re going to have to get more resources to do that. When we think about business growth, not just performance, we have to think about what’s on this balance sheet. What resources do we have? What additional resources do we need to achieve the performance on the income statement that we’re targeting?
A business that wants to grow needs more assets, and assets have to come from somewhere. The equation tells you the whole menu, because there are only two sides to the right-hand side. You borrow, the owners put in more, or the business earns it and keeps it.
Here is the simplest possible balance sheet. We are going to invest $10,000 in a business born today that hasn’t done anything, no transactions. This is what it would look like.
| Assets | Amount |
|---|---|
| Cash | $10,000 |
| Total Assets | $10,000 |
| Liabilities and Owner’s Equity | Amount |
|---|---|
| Owner’s Equity | $10,000 |
| Total Liabilities and Owner’s Equity | $10,000 |
What’s the business got? We look for the asset side, the things of value that can be used to benefit the business. It’s the cash we’ve put in. Cash for $10,000. That is the one and only line item, and total assets are $10,000.
On the liabilities and owner’s equity side we don’t have any liabilities. There’s nothing there. But we do have owner’s equity, which is what we put in, $10,000. The total of liabilities plus owner’s equity is $10,000. We have no debt yet, and we put in $10,000. This is the first day we started this business, and it balances. Assets still equal liabilities plus owner’s equity.
Now run the same business with a lender in it.
| Assets | Amount |
|---|---|
| Cash | $15,000 |
| Total Assets | $15,000 |
| Liabilities and Owner’s Equity | Amount |
|---|---|
| Loan Payable | $5,000 |
| Owner’s Equity | $10,000 |
| Total Liabilities and Owner’s Equity | $15,000 |
The owner put in the same $10,000. The business now has $15,000 to work with. Nothing about the owner’s contribution changed; what changed is how much arsenal the business is operating with, and who has a claim on it.
Imagine two businesses with the same number of assets. One of them is all self-financed with the owners’ money, so there’s no debt. The other is all debt.
The owners of the second one don’t have very much at stake in this business. They’ve used debt to finance all of it. When you take assets minus all the debt they have, there’s very little left. They don’t own much of this business. If they had to liquidate right now, they could sell all their assets - that’d be a big pile of money - but they have to pay off all their debts. There wouldn’t be very much left, and they wouldn’t have very much to show for it from this business. Which makes sense, because they haven’t put very much into this business.
From a liquidation standpoint, you can’t set up a business and then liquidate it just using debt and expect to create a lot of money. That doesn’t happen. You actually have to create value with this business.
Now imagine you’re operating and suddenly we fall on hard times, or a recession. Sales fall by 20 percent. If this is all your business and you don’t owe anybody anything, that stings, because you’d like to earn more money and it means you’re going to earn less this year. If you financed it all with debt, it’s doubly hard, because they still need to get paid. They still need to get their money back, or they need to get their interest, and you don’t have money from the operations of the business to pay that off.
That is risky, and that’s what happens when you’ve got a lot of leverage. When things are going well it’s like earning money with other people’s money. When the business is not going well, you still have to pay off your debt holders, and if the business isn’t doing well, that creates a more stressful situation.
Same arsenal. Different position. The balance sheet is where you can see the difference, and the income statement is where you cannot.
The thing with balance sheets is that we put things on at the value we acquired them for. We use this principle called historical cost. When you buy something, we assume that whatever you paid for it is the value of it, and that’s what goes on the balance sheet.
You might say that over time something can change in value. Let’s say you bought some real estate at a certain price, and five years later it might be worth more, because somebody would pay more for it. We don’t change that and alter it on the financial statements, and there are a couple of reasons why.
First, that gets to be arbitrary, and we’re not sure what we’re doing. What would be nice is that when we say this is the value, we can show a receipt for it. We use the historicals even when sometimes that doesn’t seem accurate. At least it’s more reliable.
Second, we’re not using the balance sheet to reflect what I’d call true market value. Market value could change depending on whether there’s some buyer out there who’s going to buy this asset, or the collection of assets, and at what price. That is arbitrary, and it could change from year to year, and that would be challenging to keep tracking.
What we really want to do is understand whether we are making money based on what we have spent. On the balance sheet we like to keep things at historical cost, which is more reliable. When we use our metrics to say what our return is, we want to have a return on what we’ve paid - not a return on the opportunity cost, which is more subjective and difficult to track, and which can change year to year as different people would want your assets.
So we keep everything at historical cost. That can be tricky, because when you look at a balance sheet, it might not reflect the true value of all the assets and therefore what the business is now worth. But it is a more reliable number, and it gives you more informative analytics coming out of it, rather than something that’s always changing up and down and totally subjective.
Notice what has been traded here. The balance sheet gives up on telling you what the business is worth in order to tell you, reliably, what the business has spent. Every return measure you will meet in Chapter 5 is built on that second number, which is why the trade is worth making - and why you should never read a balance sheet as an appraisal.
The income statement and the balance sheet are informative, and they are good for running a business. But there are a couple of things that are genuinely missing.
The one I think about is people. People’s talent, their energy, their loyalty. These are all things that can help a business run, and sometimes they’re the difference maker. A lot of people like to think about how the people on your team are an asset, because their presence does make the business more valuable. But you’ll notice we don’t put people on a balance sheet. You don’t see the value of that.
It goes to show a typical thing in the world: just because we don’t put a number on it doesn’t mean it’s not there. There are some things that can make a big difference that aren’t measured, and they’re not measured on the balance sheet because it’s difficult to come up with what that number would be. It’d be subjective. We never pay for that cost, and we run the expense of paying people’s salaries on the income statement instead.
Some things are hard to put a number on, including all these people, their loyalty, their thoughts, what they’ve learned, their cumulative experience. These are more subjective measures, and sometimes they make all the difference, but we don’t see them on the balance sheet.
We have to remember that when we’re using financial statements, we get a lot of insight, but it doesn’t capture everything. Sometimes you have to get creative about how to capture that angle, or recognize that the perspective we have is not quite the complete picture.
That is the honest place to end the equation. It always balances, and it never tells you everything. The next section is about what happens to it when the business actually does something.
© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 170 - please do not repost or redistribute without permission.