A balance sheet is one of the most helpful tools for a business owner because it shows the real health of a company. It is one of the three financial statements that, all together, can give you a picture of the overall financial situation of your business and can help evaluate it. The other two financial statements are the cash flow statement and the profit & loss statement, which sometimes can be called the income statement.
It canāt be overstressed that maintaining regularity in producing and analyzing balance sheets is crucial for businesses, as 29% of all businesses fail due to running out of cash ā an issue that can be tackled early by comparing current assets and liabilities. We hope that you will be able to utilize the unique power of balance sheets in order to ensure your businessā growth and success!
So letās take a closer look at what a balance sheet is, and what useful insights you can learn from it as a business owner.
How the balance sheet in accounting is formed: definition and examples
The balance sheet provides an overview of the financial health of a business at a specific short period of time. So thatās why it is important to constantly compare the new one with the previous reports to see the whole picture.Ā
Who can prepare a simple balance sheet:
- Company bookkeeper
- External accountant
- Owner
Just donāt forget to automate the process!
The balance sheet is formed by using a double-entry system of bookkeeping, with all transactions being recorded in at least two different accounts. What this means is that each transaction has both: a corresponding positive and a negative entry. Every entry has its corresponding credit and debit.
In keeping the records all the recorded transactions should be in balance according to the following formula:
Assets = Liability + Equity
In such a balance sheet assets stand for all things the company owns and has to pay for, liabilities represent the borrowed money and shareholder’s equity is the money taken from investors.
If something in the equation does not end up matching or balancing, this tells you that you have probably made a mistake recording one or several transactions or entries.
š Take a look at a sample balance sheet
Hereās what a sample balance sheet looks like, in a proper balance sheet format (Synder accounting):
Letās look deeper into each of the components.
What are Assets in balance sheet?
Assets are the things that a business owns. The cash in the bank account, the inventory of finished products, the rent/rentals for the office space and other equipment are the most important ones.
They are divided into the current assets ā can be converted to cash in 1 year or less:
- Cash and cash equivalents (treasury bills and short-term certificates of deposit);
- Marketable securities (equity and debt securities);
- Account Receivable (what the customer owes the company);
- Inventory;
- Prepared expenses (insurance, rent, etc.).
And non-current (long-term) assets ā can not be converted to cash:
- Long-term investments;
- Fixed assets (land, machinery, equipment, etc.);
- Intangible assets (intellectual property and goodwill).
What are Liabilities in balance sheet?
A liability is a debt that a business owes to someone else. In a typical balance sheet, the main distinction between liabilities and assets is that assets have a ādollar amountā and liabilities have an āamount.ā
Liabilities are the money that a company has to pay back to outside parties. They consist of current (due within one year: accounts payable, taxes, payroll, credit card payments) and long-term liabilities (after one year: outstanding loans minus the current payments, mortgages).
š Keep in mind that some liabilities are considered off the balance sheet so you could not find them in the reports. Off-balance sheet items are typically those not owned by or are a direct obligation of the company.
What is Shareholdersā equity?
A share of equity means the ownership stake in a company that belongs to other people. It represents the share of profits generated by the company. When calculating a companyās share of shareholdersā equity, itās not the net income of the company, but the operating cash flow of the business, which is the amount of money left over after paying for necessary expenses ā payables, salaries and investments, among other things.
Shareholdersā equity might include:
- retained earnings
- common stock
- treasury stock
- paid-in capital
š If shareholdersā equity is positive that means the company has enough assets to cover its liabilities, but if it is negative, then the companyās liabilities exceed its assets.
How can a balance sheet help you as a business owner?
āļø It sheds light on the risks which you may face and shows the positive outcomes
One of the most significant benefits of keeping a succinct balance sheet in accounting comes from their content, which is mainly having both assets and liabilities in one place. Both current and long-term assets speak about a businessā ability to produce cash and keep its operations running. Debts, both short and long-term, help prioritize the obligations a business has. Ideally, a thing to strive for would be having more assets than liabilities, which would signal a positive net worth.
When you compare current assets and current liabilities in your balance sheet, you can see whether the business is able to cover its immediate obligations. If current liabilities exceed the cash you have available, it shows that your business may need to seek outside working capital.
You can also see from a balance sheet when the levels of debt become unsustainable. That happens when there is too much debt on your balance compared to the existing current assets and may lead to having to either default on debt payments or declare bankruptcy.
A rule of thumb, which is good to keep in mind, is that if the ratio of assets to liabilities is less than 1 to 1, the company is in danger of bankruptcy, so for you, as a business owner, it will mean that some strategic improvements are necessary in order to stabilize the companyās financial health.
āļø It builds up your trustworthiness in the eyes of investors and lenders
A great thing about the balance sheet is that it allows people outside of your company to very quickly understand your financial condition, without you having to persuade anyone. The numbers will speak for themselves.
Most lenders in fact require a balance sheet to determine a businessās financial health and its creditworthiness. Potential investors may also use it to understand where their funding will end up and when they can expect to be repaid (for this, itās important to be able to show your ability to pay your business obligations on time and in full measure).
When you update a balance sheet (important to notice here that it needs to be done on a regular basis and a balance sheet in accounting always needs to be titled with a date, as it shows the health of a business for a particular period in time), it shows your ongoing ability to take payments and repay debts. It also shows lenders that you have a track record of successfully managing assets and liabilities. When you apply for loans, you can use a simple balance sheet to show lenders that you are very likely to repay your debts on time.
In fact, a carefully maintained balance sheet can be described as a single most potent tool that can be used in order to demonstrate that a business can be trusted.
āļø It provides you with unique ratios that demonstrate the health of a business at any given time
There are certain techniques that can be used to analyze a balance sheet in greater detail. The main one is the financial ratio analysis, which is described in detail here. The ratio analysis in short is a quantitative method of gaining insight into liquidity, profitability, and operational efficiency by comparing its main financial statements such as the income statement and balance sheet.
Among some other ratios that can be used are the debt-to-equity ratio, which can provide a good sense of the companyās financial condition. More information on this ratio can be obtained here. Normally these ratios need more than just the balance sheet, income statements often being necessary as well.
Things like activity ratios mainly focus on current accounts in order to show how well the company manages its operating cycle (this report would include receivables, inventory, and payables).
In general, these and other accepted ratios can provide even more insight into the companyās operational efficiency than a balance sheet alone, but even just having a well-maintained balance sheet as well as a practice of regularly analyzing it can be a great way for business owners of any types of businesses to stay on top of their operations.
We have taken a deeper look into a vital part of the business: the balance sheet. We have discussed in detail the main factors that are a good place to start with when evaluating the balance sheet of your business, and how to make better and more informed decisions.
However, in spite of these important insights, we should not forget that the balance sheet is just one part of a full-fledged financial audit. Besides reviewing the current state of affairs, you should also evaluate the past: in order to know what factors affect your balance sheet the most, you need to dig deeper.
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