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What is a Balance Sheet?

As a small business owner, understanding the balance sheet is critical to the financial health and success of your company. A balance sheet, also known as a statement of financial position, provides a snapshot of a company’s assets, liabilities, and equity at a specific point in time. It is one of the most important financial statements for a business, as it gives insight into the company’s liquidity, solvency, and overall financial stability.

It shows what a company owns (assets) and owes (liabilities + owner’s equity), and gives the overall picture of the financial position of the company.

In essence, the balance sheet is inspired by the fundamental accounting equation which states that the total assets of a company must equal the total liabilities of the company and owner’s equity. That being said, for the balance sheet to be accurate, the assets must equal the sum of liabilities and owner’s equity.

It is usually prepared every 12 months in normal trading conditions. However, some companies prepare it at the end of an accounting period such as month-end, quarter-end, or year-end.

Components of the Balance Sheet

Assets

Assets are resources that a business owns or controls, and that have a monetary value. They can be divided into two categories: current assets and long-term assets.

Current assets are assets that can be converted to cash within one year. They include cash, accounts receivable, inventory, and prepaid expenses.

Long-term assets are assets that have a useful life of more than one year, and cannot be converted to cash within one year. They include property, plant, equipment, investments, and intangible assets such as patents and trademarks.

Liabilities

Liabilities are obligations that a business owes to others. They can also be divided into two categories: current liabilities and long-term liabilities.

Current liabilities are obligations that are expected to be paid within one year. They include accounts payable, short-term loans, and taxes owed.

Long-term liabilities are obligations that are expected to be paid over a period longer than one year. They include long-term loans, bonds, and leases.

Equity

Equity is the residual interest in the assets of a business after liabilities are deducted. It represents the owner’s claim on the assets of the business. It can be divided into two categories: shareholder’s equity and retained earnings.

Shareholder’s equity represents the value of the business that is owned by the shareholders. It includes common stock, preferred stock, and additional paid-in capital.

Retained earnings represent the net income that a company has earned, less any dividends that have been paid to shareholders.

Assets are of two types: current and non-current assets. Liabilities are also further subdivided into current and long-term liabilities while owner’s equity comprises shares and retained earnings of the company.

Balance Sheet & Accounting Equation

The Balance Sheet reflects the fundamental accounting equation which is written as:

Assets = liabilities +owner’s equity

The equation also represents the structure of the balance sheet since assets are written on one side of the balance sheet and liabilities & owner’s equity on the other.

Balance Sheet proforma for Small Businesses

Here is an example of the balance sheet that can be used for small and medium-sized entities (SMEs).

Assets	000 $	Liabilities + owner’s equity	000 $
Current assets		Current liabilities
Accounts receivable	1120	Accounts Payable	1290
Cash	700	Interest Payable	700
Inventory	2830	Taxes	1700
Total current assets	4650	Total current liabilities	3690
Non-current assets		Long term liabilities
Land	6000	Notes Payable	5600
Building	1560	Bonds Payable	3000
Equipment less accumulated depreciation	1940	Total long-term liabilities	8600
Other assets	1000	Equity
Total non-current assets	10500	Common stock	5000
		Retained earnings	1550
Total assets	15150	Total liabilities and equity	15150

As it is evident from the sample balance sheet above, the total assets must equal the sum of total liabilities and equity. If it is not balanced then there must be some error, maybe the data is incomplete, or wrong, or some transactions may be omitted or wrongly entered.

To prepare the balance sheet for small businesses, add up the current and non-current assets of your company on the left side of the balance sheet, and on the right side, add up the current and non-current liabilities of your company to arrive at the total liabilities figure. The next step is to calculate the total equity and add the equity figure to the total liabilities figure. If you do it correctly, both sides of the balance sheet should be equal.

Some businesses will have a simpler balance sheet specifically small businesses that do not have notes, bonds, and retained earnings. On the other end, the balance sheet could be way more complicated than the sample when it involves items such as intangible assets, accrued expenses & liabilities, marketable securities, and unearned revenues.

Reading and Interpreting a Balance Sheet

Unlike the statement of Profit & Loss (P&L), the balance sheet does not have any varying final figures such as profit, and therefore, you cannot just simply compare the balance sheet as a whole. However, there are Financial Ratios that you can use to evaluate each item or class of a balance sheet in isolation.

• Current Ratio: This ratio is used to measure the company’s capability to pay current liabilities with the current assets. It is calculated by dividing the total current assets by the total current liabilities. In the above balance sheet template, it can be calculated as:
  = 1.26 (4650/3690)
  It means that the company will have no problems paying off short-term liabilities using the current assets. Generally, the higher the current ratio, the better. However, it should also be compared with the prior year’s current ratio and/or your competitor’s current ratio to have a benchmark for evaluation purposes.
• Quick Ratio: Variation of the current ratio with a slight change, the quick ratio is calculated by dividing the total current assets minus inventory by the total current liabilities. Here is how:
  = 0.49 [(4650-2830)/3690]
  That means, without inventory, the company will have problems paying off short-term debts upon liquidation. It is also compared with prior years’ and competitors’ quick ratios to have a better understanding of the performance of the company.

Importance of Balance Sheet for Small Businesses

The Balance sheet is one of the most important financial statements and can give you many important pieces of information individually as well as along with other statements like Income Statements or Cashflow Statements.

• It can be used to determine the liquidity of a company by comparing its current assets with current liabilities. Liquidity is referred to as how much the company’s current assets (which can be readily converted into cash) are worth against its current liabilities.
• It can also be used to measure the growth of the company by comparing it with the prior year or industry average.
• A good balance sheet can be helpful while applying for a loan from banks or investors.
• The Balance sheet can tell its readers about the leverage of the business whether the company is mostly run by its own equity or debt.
• We can also determine small businesses’ profitability by calculating their return on assets and return on equity. We simply divide net income (income statement item) by total assets (balance sheet item) and total equity (balance sheet item) respectively.
• Balance sheets do clarify how efficiently small businesses are utilizing their assets to generate revenue.
• At the time of the audit, external auditors use the balance sheet to evaluate whether a company is following accounting standards or not.

Monitoring your Balance Sheet

There are several key steps to monitoring the balance sheet of a company:

1. Review the balance sheet regularly: It is important to review the balance sheet on a regular basis, such as at the end of each month or quarter. This will allow you to stay up-to-date on the financial health of the company and identify any potential issues early on.
2. Compare to industry averages: Compare the company’s balance sheet metrics, such as the current ratio and debt-to-equity ratio, to industry averages. This will give you a sense of how the company compares to its peers.
3. Analyze trends: Look for trends in the balance sheet over time. Are assets and liabilities increasing or decreasing? Are the ratios improving or deteriorating? Identifying trends can help you understand the underlying financial performance of the company.
4. Use financial ratios: Financial ratios can provide valuable insights into the balance sheet. For example, the current ratio measures a company’s liquidity, while the debt-to-equity ratio measures leverage. These ratios can help you identify potential financial risks or opportunities.
5. Consult with a financial advisor: If you have any doubts about interpreting the balance sheet, it’s always good to consult with a financial advisor. They can provide valuable insights and help you understand the financial information presented in the balance sheet.

By regularly monitoring the balance sheet and using the above strategies, you will be able to gain a better understanding of the financial health of your company and make informed business decisions.

Conclusion

Understanding the balance sheet is crucial for small business owners. The balance sheet provides a snapshot of a company’s financial health and is an essential tool for making informed business decisions. By regularly reviewing the balance sheet, comparing it to industry averages, analyzing trends, using financial ratios, and consulting with a financial advisor, small business owners can gain a better understanding of their company’s financial position and identify potential risks and opportunities.

It is important to remember that the balance sheet is just one of the many financial statements that a business owner should review. It should be used in conjunction with the income statement and cash flow statement to get a complete picture of the financial health of the company.

In short, a balance sheet is a powerful tool that small business owners can use to make informed decisions and ensure the long-term success of their company. By taking the time to understand the balance sheet and use it effectively, small business owners can set themselves and their companies up for success.