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As a small business owner, it’s important to understand how to read and analyze a balance sheet. Along with the income statement and cash flow statement, the balance sheet is one of the three key financial statements you need to evaluate the performance of your business. The balance sheet provides the big picture — it summarizes what your business owns, what it owes, and what it’s worth at a given moment in time. Read on for a simple guide to understanding a balance sheet.
What Is a Balance Sheet?
The balance sheet provides a snapshot of a company’s financials at a given moment in time. It summarizes what your business owns (its assets), what your business owes (its liabilities), and what is left over for the owner or owners (called owner’s/owners’ equity). Typically, a business will prepare a balance sheet at the end of an accounting period, such as a month, quarter, or year.
What Is Included on a Balance Sheet?
Part of balance sheet analysis is understanding the three main components of a balance sheet. Together, these three parts tell the story of the company’s financial well-being.The information in a balance sheet is based on the following equation:Assets = Liabilities + Owners’ EquityHere’s a look at each component.
Assets
An asset is anything of value that a company owns. Assets are considered positives on a balance sheet and are typically divided into short-term (or current) or long-term (noncurrent).Short-term, or current, assets generally include anything a business can convert into cash within a year, such as:
Cash
Cash equivalents (e.g, currency, stocks, and bonds)
Long-term, or noncurrent, assets are investments that couldn’t be converted into cash with a year and include:
Land
Buildings
Machinery and equipment (minus depreciation)
Intangible assets, such as patents, trademarks, copyrights, and goodwill (you would list the fair price a buyer might pay to purchase these)
Long-term investments
Liabilities
A liability is something your company owes, rather than owns. These are financial obligations that need to be paid to a debtor or creditor and are tallied as negatives. Liabilities are also divided into short-term (or current) and long-term (or noncurrent) liabilities.Short-term liabilities are due within a year and include:
Accounts payable (what you owe suppliers for items you bought on credit)
Wages you owe to employees for hours they’ve already worked
Long-term, or noncurrent, liabilities have a due date that is more than a year away. These include:
Loans that you don’t have to pay back within a year
Bonds your company has issued
Leases
Provisions for pensions
Deferred tax liabilities
Equity
The third component of a balance sheet is owner’s or owners’ equity (for corporations, it’s known as shareholders’ equity). This is what’s left over after all liabilities have been paid and it belongs to the owner or owners of the company. If you were to add up all of a company’s assets and subtract all of its liabilities, what you get is the owners’ equity.Owners’ equity typically includes the money the owners have invested, along with any earnings the company has made and retained.
What Do Balance Sheets Indicate?
So why is reading a balance sheet important, and who needs to read it?As a business owner, a balance sheet can give you key insights into the financial health of your company. It allows you to compare your current assets to your current liabilities to determine your liquidity. It also tells you your company’s current book value (or the total amount all owners would get if you liquidated the company). In addition, it can be helpful to compare two or more balance sheets over time to see how much your business has grown.If you ever apply for a small business loan, a potential lender will likely also be interested in seeing your company’s balance sheet. By looking at how your current assets compare to your current liabilities, a lender can assess whether or not your business can fulfill its short-term obligations. This helps them determine how much of a financial risk it would take by extending your company a loan.Any potential investors in your business will also be keen to review your balance sheets to better understand your company’s prospects.
Important Ratios Associated With Balance Sheets
Once you learn how to read balance sheets, you’ll find you can do so much more with them, including calculating key financial ratios. Here’s a look at three revealing calculations you can make from your balance sheet.
Debt-to-Equity Ratio
The debt-to-equity (D/E) ratio tells you whether a company raises money through investment or debt. A high D/E ratio indicates that a business relies heavily on loans and other types of financing to raise money. To calculate your D/E ratio, you simply divide liabilities by owners’ equity, both found on the balance sheet:Liabilities/Owners’ Equity = Debt-to-Equity RatioNew businesses tend to have higher D/E ratios, since they may be relying on loans to get up and running. Established companies may also need debt to expand through strategies like buying new equipment or purchasing a larger warehouse.
Current Ratio
The current ratio allows you to measure your company’s liquidity — or, in other words, its ability to pay off its current liabilities using its current assets. To calculate your current ratio, you divide current assets by current liabilities:Current Assets/Current Liabilities = Current RatioA current ratio over 1 is considered healthy because it means the business is capable of paying its short-term obligations. A current ratio below 1, however, suggests that the company is not able to pay off its short-term liabilities with cash.
Quick Ratio
Sometimes taking the business’s inventory out of the current ratio helps give a more realistic view of a company’s finances. The quick ratio measures a firm’s ability to pay its current liabilities without needing to sell its inventory or take out a loan. It is considered a more conservative measure than the current ratio.(Total Current Assets – Total Current Inventory) / Total Current Liabilities = Quick RatioA quick ratio of 1 and above indicates that a business has enough liquid assets to fully cover its debts.
Balance Sheet Example
Here’s an example of a balance for a fictional company called ABC.Company ABC Balance Sheet, December 31
Current Assets
Cash
$8,000
Accounts receivable
$28,000
Inventory
$20,000
Total current assets
$56,000
Non-Current Assets
Plants and machinery
$16,000
Less depreciation
-$9,600
Land
$6,400
Intangible assets
$1,600
Total non-current assets
$14,400
Total Assets
$70,400
Liabilities and Owner’s Equity
Liabilities
Accounts payable
$16,000
Taxes payable
$4,000
Long-term bond issued
$12,000
Total Liabilities
$32,000
Owners Equity
Capital
$32,000
Retained earnings
$6,400
Total Equity
$38,400
Liabilities and Owner’s Equity
$70,400
How to Read a Balance Sheet
When reading a balance sheet, it helps to understand that assets are generally listed in ascending order of liquidity (or how easily they can be turned into cash, sold or consumed). Liabilities, on the other hand, are listed in ascending order. Under owners’ equity, accounts are typically arranged in decreasing order of priority.Another key thing to note on a balance sheet is that it should balance: Total assets should match the total for liabilities and owners’ equity. If they don’t balance, there is a mistake somewhere. A transaction may have been entered into the books incorrectly, for example, or perhaps equity wasn’t calculated accurately.
What You Can Do With the Information on a Balance Sheet
A balance gives you a snapshot, or summary, of your business at a certain point in time. It gives you insight into your company’s:
Liquidity By comparing your business’s current assets to its current liabilities, you’ll see exactly how much cash you have readily available. It’s generally wise to have a cushion between your current assets and liabilities so you’re able to cover your short-term financial obligations.
Efficiency Comparing your income statement to your balance sheet can give you an idea of how well your company can use its assets to generate revenue.
Leverage Comparing the debts to the equity on your balance sheet can help you understand how much leverage your business has and, in turn, how much financial risk it faces.
Other Tips on Understanding Balance Sheets
The balance sheet reflects every transaction your business has made since it started and, thus, reveals your business’s overall financial health. Business owners, investors, and lenders can use the information presented on a balance sheet to give your business a book value. The book value of a company is equal to its total assets minus its total liabilities.A balance sheet also tells you, and any other interested party, what resources are available to the business and how they were financed. Based on this information, a potential lender or investor can decide whether or not they want to work with your company. In addition, the information in a balance sheet can be used to calculate important metrics, such as the current ratio and debt-to-equity ratio.Recommended: Understanding Budgeted Income Statements
The Takeaway
The balance sheet provides detailed information about your business’s assets and liabilities at a certain point in time. Knowing how to read and analyze a balance sheet can help you make informed decisions about your company and help keep it on solid financial footing. The balance sheet is also a key reference document for lenders and investors, who can use it to assess your company’s financial status.
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Frequently Asked Questions
What can a balance sheet indicate?
What are the most important items on a balance sheet?
Is there such a thing as a balance sheet ratio?
Photo credit: iStock/BartekSzewczyk
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About the Author
Susan Guillory
Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.
