How to read a balance sheet
A balance sheet is a snapshot of how financially healthy your business is, and could tell you whether you’re well prepared to jump on new opportunities or even how attractive your company might be to a potential buyer or investor.
What a balance sheet includes
All balance sheets lay out three basic kinds of information about your business: assets, liabilities, and shareholders’ equity. When you look at these data together, they give you a quick glimpse of your business’s financial status.
Haven’t seen a balance sheet? Picture a page. On the left-hand side, there’s a list of assets. These are things that the business owns, such as cash in a bank account, inventory, computer equipment, receivables, even what’s called goodwill, which includes intangibles like your reputation from years of building relationships with customers, or the value of your logo and brand.
On the right-hand side, there are two columns. First, there’s a list of liabilities – what the business owes, such as accounts payable (the amount owed to vendors), obligations to banks for loans and back pay to employees.
Below that is a column for shareholders’ equity. Shareholders’ equity means anything that would be left over after all the company’s liabilities are satisfied. In a small business, the owner is often the sole shareholder.
The page you’ve just imagined is a balance sheet.
A balance sheet is based on a simple formula: Assets = Liabilities + Shareholders’ equity. This formula shows how the things a company owns (assets) were paid for. Either the owners have invested money in them (this is called shareholders' equity) or have taken out debt (liabilities) to pay for them.
The formula always balances out. So, let’s say you, as the sole owner, paid for a new set of office furniture that cost $10,000 (which would be listed as an asset). You paid $2,000 in cash and put the remaining $8,000 on a credit card. The $2,000 would be owner’s equity and the $8,000 would be a liability. That would add up to the $10,000 you spent.
What a balance sheet is used for
Balance sheets can give you clues to your business’s ability to withstand an economic or competitive shock or invest in new products and services. You can get a glimpse into how the business is performing on many fronts by looking at the ratios between the columns. For instance, a company that consistently has large amounts of cash on hand and very few liabilities may not be investing enough in growth. Or a company that has taken on a lot of debt but has few assets may need to find new ways to bring in revenue, or possibly restructure the debt, for the debt to be sustainable.
To take the pulse of their business, many small business owners keep an eye on simple ratios such as the current ratio (current assets/current liabilities), the cash ratio (cash and cash equivalent/current liabilities) and the debt-to-asset ratio (liabilities/assets).
These are just a few of the variety of ratios you can track to take the pulse of your business. Your accountant can help you determine which ratios are the most important to the health of your business.
How can you create a balance sheet?
Software programs and accounting services make it easy to create balance sheets, practically at the touch of a button. To create an accurate balance sheet, you will need to make sure your bookkeeping is up to date and that you or your bookkeeper have correctly categorized each entry.
For instance, if you took out a $20,000 loan, you would likely categorize the proceeds of the loan as “cash or cash equivalent” and put it under the liabilities category as long-term debt.
If you got an investment of $50,000, it would appear in the assets column and in the shareholders’ equity column. Revenues that exceed expenses also belong in the shareholders’ equity column.
Remember, the objective is to balance both sides of your balance sheet.
When do you create a balance sheet?
A balance sheet is something you should create early in the life of your business and maintain on an ongoing basis. Most business owners look at their balance sheets monthly, quarterly, or yearly, when they want to get a clearer picture of the underlying health of the business. The ratios become particularly useful when you establish a handful that you look at regularly and see how they change over time.
Other times you may need to create a balance sheet are when you file your business taxes, if you apply for a business loan or if potential buyers are interested in purchasing your business. The more accurate your books, the easier it will be to create a balance sheet.
It can take a while to get comfortable with balance sheets. Making time to create one with your accountant, bookkeeper or banker can help you get up to speed. There’s a learning curve, but once you know how to create one, you’ll always have your finger on the pulse of your business.
If you still need assistance with your bookkeeping needs or have other accounting questions, please call Tony Silva at (619) 477-4357 for a free consultation.