Assets = Liabilities + Shareholder’s Equity
Above is the balance sheet equation, which is saying that all assets must be funded by either liabilities (e.g. debt) or shareholder’s equity (e.g. money from private or public investors). If the equation does not balance, that means there is an error in the balance sheet.
In order to find the error, first you can see if any item looks wrong in the balance sheet. For example, if there is a huge swing in inventory that doesn’t make sense, it’s worth revisiting the math behind that number and seeing if there are any mistakes.
You can also see if assets are higher, or liabilities + shareholder’s equity is higher. See if the difference matches any particular line items you have forgotten.
Another way to find out why a balance sheet does not balance is by building lots of checks and reconciliations. For example, you can build a bridge from EBITDA to cash flow, in order to see that the buildup makes sense, and that the cash flow number you arrive at is consistent with the increase in cash on the balance sheet.
You can also see if items in the cash fl ow statement correspond with items in the balance sheet. For example, you can examine if changes in net working capital in the cash flow statement – such as accounts receivable, inventory, and accounts payable – correspond to the changes in net working capital on the balance sheet.
Another common mistake is not linking net income from the income statement to shareholder’s equity on the balance sheet.