Basics of Corporate Finance

Source of term "balance" sheet

Notice that the total of all assets is equal to the total of the liabilities and equity (286.9 at the bottom of each side of the Balance Sheet in our example). This is always true, hence the term "balance" sheet. The value of the assets equals the amount of money borrowed by the company plus the value of the owner's investment in the company. The stockholders' (common) equity, also known as net worth, is the residual between the value of the assets and the value of the liabilities. In our example Balance Sheet:

Assets - Liabilities = Common Equity (Net Worth)
286.9 - 181.1 = 105.8

Suppose that assets decline in value; for example, some of the accounts receivable are written off as bad debts. Liabilities remain constant; the value of common equity is adjusted so that both sides of the Balance Sheet remain equal. If the value of assets increases, those benefits accrue solely to the stockholders (common equity).

If, for some reason, the company is no longer able to function profitably, its assets will likely be sold. The proceeds of these sales will first be used to pay the creditors of the company and then to repay the preferred stockholders' investment. Any remaining proceeds are divided among the common shareholders. You can see why stockholders' investments are often thought of as "risky".