The Extended Balance Sheet

Notes from Topic 1 of the course Asset Structure and Investment Vehicles.

What is the balance sheet

The balance sheet is one of the main financial statements. Financial statements or annual accounts are accounting reports that summarize the economic situation of a company over a given period. Financial statements are composed of:

• Balance sheet
• Income statement
• Cash flow statement
• Statement of changes in equity
• Notes to the financial statements

The balance sheet is a “snapshot” at a given moment (for example, as of December 31, 2025) listing and valuing the full set of rights and obligations of the company.

The balance sheet is composed of assets, liabilities, and equity, which are related through its fundamental equation: Assets = Liabilities + Equity

Assets consist of all the company’s resources expected to generate income in the future. Liabilities consist of all debts and commitments the company has with third parties. Equity shows the value of a company after deducting its debts — that is, what portion of the assets belongs to or is financed by the owners’ or shareholders’ own resources. Liabilities and equity show the sources of financing of the company.

Operating cycle: inventory, receivables, cash

Working capital: current assets — current liabilities

By convention, when drawing a balance sheet the assets are placed on the left and liabilities on the right. By convention, both assets and liabilities are usually ordered by liquidity or maturity (collection or enforceability). In some regions they are ordered from most to least liquid, and in others the reverse.

A distinction is normally made between financial liabilities (debts) and equity (or non-enforceable liabilities), although in reality there is no well-defined line but rather a continuum (ordinary shares, preferred shares, convertible bonds, perpetual debt, subordinated debt, secured debt…). That is why in this course, unlike standard textbooks, we will refer to liabilities in the broad sense — that is, we will consider equity as part of liabilities. In the same way we will speak of owners in the broad sense, including all creditors.

The 2 survival constraints of the company are:

• Equity > 0. If equity is negative, enforceable liabilities exceed assets and the company will not be able to meet all its future obligations. This is a solvency crisis and the company will go bankrupt.
• Cash > 0. If the company runs out of cash it will not be able to meet its short-term obligations. This is a liquidity crisis and the company will become insolvent.

A company can have liquidity problems without having solvency problems, and vice versa.

Accounting is not unambiguous — the same situation could be represented in multiple ways depending on the criteria chosen: when we recognize a commitment, an expense or revenue, how we value things, how we depreciate an asset… To unify and standardize these, accounting standards exist.

The balance sheet will be the central axis of this course. We will see that it is a very fertile framework both for situating and understanding any asset we encounter and for applying it to our personal finances. For this we do not need to know accounting standards or valuation — we are only going to use the balance sheet conceptually. To develop that intuition about the balance sheet, in the following sections we will explore 3 somewhat less orthodox perspectives on how to interpret it:

• Economic view: The balance sheet as a flow of income
• Legal view: The balance sheet as property rights
• Functional view: The balance sheet as a management tool

Resources:

• Balance sheet (wikipedia)
• Financial statements (wikipedia)
• Double-entry bookkeeping (wikipedia)
• International Financial Reporting Standards (wikipedia)
• International Accounting Standards (wikipedia)
• US GAAP (wikipedia)
• How to understand a balance sheet — Borja Roibas (video)

The balance sheet as a flow of income

The balance sheet shows a summary of something deeper. Each element of the balance sheet, each asset and each liability, represents a flow of future income. These income flows can be perpetual or time-limited, continuous or discrete, equal or unequal, constant or irregular, growing or declining; they can be spread across time or concentrated in a single moment, more or less distant in time, more or less certain and probable.

By income we mean any flow of goods, services or money that provides utility to the agent. These income flows have a time component and a certainty or probability component. This temporal and certainty dimension is lost when summarized in the balance sheet, but we must keep it in mind for a deep understanding of the agent’s economic situation.

Various accounting and valuation criteria exist: cost, replacement, sale, cash flows, comparables, multiples… These criteria are a practical matter that does not concern us here. In certain cases one may be more appropriate out of prudence or because accounting regulations require it. But that does not change the conceptual aspect: each asset and liability is the present value of a flow of income. When one attempts to value something by directly estimating this future flow of income, we speak of fundamental value or fundamental analysis. In practice, discounted cash flow analysis is only used for highly predictable flows.

Financial mathematics. Discounting, compounding. Compound interest. Net present value. Internal rate of return.

This income flow can be incoming, from the asset side, or outgoing, from the liability side. That is, on the asset side appear all the sources of income, and on the liability side all the destinations of income.

That is why I like to say that assets produce income and liabilities consume it. This is true at least in relative terms, in the context of the agent whose balance sheet we are drawing. And ultimately it is also literally true in the aggregate context. If we lifted the veil of financial assets and liabilities and consolidated the balance sheets of the entire economy, we would see that only productive assets remain as sources of income and consumption preferences as destinations of income.

We can see that assets and liabilities are not 2 separate things but 2 sides of the same coin. Both refer to the same reality, to the same income that will come in and go out, or that will be produced and consumed. Separating that reality into 2 sides is simply convenient for working with it. Pipeline analogy: a cross-section toward which fluid enters or from which it exits.

Resources:

• Financial mathematics (wikipedia)
• Net present value (wikipedia)
• Internal rate of return (wikipedia)

The balance sheet as property rights

The balance sheet is a way of showing property rights. On the asset side appears the thing that is owned; on the liability side, who owns it.

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Property rights are a useful idea that has evolved over generations. It is the idea that something belongs to someone else and I must not or have no right to use that thing or make decisions about it.

The specific content of property rights may change over time and be affected by customs and laws, but in general we can distinguish two components: political rights and economic rights. Political rights refer to the capacity to decide how the thing should be used. Economic rights refer to the appropriation of what the thing generates or produces.

Today these rights are defined and limited by law. Economic rights find a forced partner that claims a percentage of each income stream in the form of taxes. And political rights find their limits in the regulations that determine what can or cannot be done, the licenses required, or the various conditions for each activity.

Property rights have significant economic implications and are the result of a prolonged moral, cultural and legislative evolution. They allow the stable assignment of decision-making capacity (political rights) and incentives (economic rights) over resources, reducing uncertainty and making long-term planning possible. This assignment enables the division of knowledge and specialization — more than a mere division of labor. This specialization in knowledge is probably why society is more than the sum of individuals in productive terms. See “I, Pencil.”

On the liability side are the owners of the thing, and we said that the thing is nothing but a flow of income. If the owners hold a proportional share of the thing, they will all have equal rights to decide and to keep a proportional share of the income the thing produces. But the owners could agree to something else: one owner might want to be paid first while another might not mind being paid later.

That is, the owners could distribute the flows in a temporally (or conditionally) unequal way, resulting in the liability side being a list of claims on future flows. We will call this a symmetry breaking of flows.

When there is a symmetry breaking, some owners will become creditors (of a debt) and others will become shareholders. This breaking also implies 2 things:

• Priority of payment. In the event of bankruptcy, not all owners and creditors will have the same rights. Shorter-term or less speculative creditors will be paid first, and shareholders will be paid last and only from what remains.
• Political rights. This assignment of rights concentrates decision-making capacity in the longest-term owner, which favors specialization in the use of the asset and reduces the principal-agent problem.

Resources:

• Symmetry breaking (article)
• Division of knowledge — Jesús Huerta de Soto (video)
• I, Pencil — Leonard E. Read (article)
• I, Pencil — Leonard E. Read (video)

The balance sheet as a management tool

The balance sheet does not only serve to convey information about the economic situation of an agent — it is also a management tool. Building the balance sheet forces us to explore and estimate those future incoming and outgoing income flows, which allows us to anticipate the future and make decisions today to correct it.

Some authors call this practice Asset-Liability Management / Matching (ALM) or, in some contexts, Liability-Driven Investing (LDI). It consists of aligning assets and liabilities in terms of maturity and risk profile — that is, ensuring that the timing and certainty of incoming flows match those of outgoing flows. Or seen from another angle: transferring income across time through investment or borrowing.

This is an extremely powerful conceptual framework when applied to personal finance. It is already largely present when we talk about investor profile, goal-based investing, emergency funds, and so on. What this balance-sheet-as-ALM approach achieves is to connect all these points within a global and structured framework.

Applying this framework to our own finances, we could speak of assets as resources and liabilities as desires or temporal consumption preferences — or, in Austrian terms, we could speak of the balance sheet as a way of encapsulating the means-ends framework. Here we again see very clearly that assets and liabilities are a single reality: something is valuable because someone desires it. We can also understand why this is liability-driven and not asset-driven. There is a hierarchy, and liabilities lead: it is about having what we want, not about wanting what we have.

In accounting, liabilities are usually interpreted as a historical fact: shareholders and creditors financed the company because they contributed resources in the past. But from an economic point of view, liabilities reflect something deeper: the existence of intertemporal preferences. The productive structure is an organization of resources aimed at generating future income, and it can only be sustained because someone is willing to defer present consumption in exchange for future consumption. Shareholders and creditors finance the company not only because they contributed capital at its inception, but because they could liquidate or redirect the assets toward more immediate consumption ends — and they choose not to. What is sustaining, enabling, financing that productive organization is, at its core, a preference, a desire.

We will not go deeper here, but to approach an individual’s balance sheet one would need to consider at least 2 points:

• Human capital. This will be the largest asset for any young person. It can have different maturity profiles and risk profiles (self-employed, civil servants, higher education, performance-linked bonuses…).
• Net worth as desires or commitments to oneself.

Standard textbooks (such as CFA III Private Wealth pathway) speak of a holistic balance sheet, economic balance sheet, or extended balance sheet. The personal extended balance sheet is a fundamental tool of goals-based planning that provides a comprehensive view of one’s economic situation by including both explicit and implicit assets and liabilities:

• Explicit assets: These are current tangible and financial assets, such as bank accounts, investment portfolios, residential real estate, and other personal assets.
• Implicit assets: These represent future resources that are difficult to quantify and require assumptions about mortality and inflation. The most significant is usually human capital (the present value of future labor income), but also includes expected pensions, stock options, the value of family businesses, and projected inheritances.
• Explicit liabilities: These include current and legal debts, such as mortgages, student loans, credit card debt, and outstanding taxes.
• Implicit liabilities: These represent the present value of future spending plans. The largest implicit liability is usually lifestyle maintenance, followed by dynastic goals (legacies for heirs), healthcare expenses in retirement, and philanthropic commitments.

Resources:

• Liability-driven investment (wikipedia)
• Asset and liability management (wikipedia)
• Liability Matching Strategy (investopedia)
• MatchedBook: ALM in personal finance (audio)
• Matching income and expenses — Domingo Soriano (video)
• The balance sheet as means and ends (article)
• Wealth Planning — CFA III Private Wealth pathway (programme)
• The personal extended balance sheet — CFA III Private Wealth pathway (podcast)

The 4 operations of the balance sheet

Contraction: paying down debt, share buybacks, dividends, consuming

Expansion: raising equity, borrowing, saving

Asset swap: buying, selling

Liability swap: conversion, refinancing, change of preferences

Example:

• t=1 (expansion): you take out a loan
• t=2 (asset swap): you buy a house
• t=3 (liability swap): you refinance the loan (changing term, payment, collateral…)
• t=4 (contraction): you pay off the debt