The balance sheet (or statement of financial position) is one of the three basic financial statements that every business owner analyses to make financial decisions. Owners also review the income statement (Profit & Loss report) and the cash flow statement.
A balance sheet reports your firm’s assets, liabilities and equity as of a specific date. This discussion explains each component of the balance sheet in detail, and provides some ratios that can help you make better financial decisions.
The accounting equation (also known as the balance sheet formula) is a great tool to understand how these concepts fit together.
Assets, liabilities and equity – defined
Here are the components of a balance sheet:
- Assets – What your business owns. Assets are resources used to produce revenue and have a future economic benefit.
- Liabilities – Amounts your business owes to other parties. Liabilities include accounts payable and long-term debt.
- Equity – Equity is the difference between assets and liabilities, and you can think of equity as the true value of your business.
The components are connected by the balance sheet formula:
Assets = liabilities + equity
The formula is used to create the financial statements, including the balance sheet.
What are assets?
In accounting, assets are the resources used to produce revenue.
Accounting standards require firms to separate assets and liabilities into current and non-current categories.
Current assets include cash and assets that will be converted into cash within 12 months.
- Cash and cash equivalents: The total amount of cash on hand. Cash equivalents refer to short-term, high-quality investments, including certificates of deposit (CDs) and commercial paper.
- Accounts receivable: The amount your customers owe you after buying your goods or services on credit.
- Inventory: Items purchased to sell to customers.
- Prepaid expenses: Expenses you’ve paid in advance, such as six months of insurance premiums. These cash payments are assets, because the cost has already been incurred.
- Investments: Money-market account balances, stocks, and bonds. Some investments may be categorised as non-current, but most are current assets. Investments in this category are also defined as marketable securities.
- Notes receivable: Amounts you are owed that will be paid within 12 months.
Non-current assets are not converted into cash within 12 months.
Your business may own fixed assets and intangible assets, and these accounts may be referred to as long-term assets.
- Fixed assets: Fixed assets include vehicles and equipment used to produce revenue. These assets decrease in value over time. For that reason, depreciation expense is posted to record the decline in value of fixed assets. Real estate (land) is posted to the fixed asset category, but land does not depreciate in value.
- Intangible assets: Assets that have no physical manifestation, such as goodwill, patents and trademarks fall into this category.
The balance sheet may also include current liabilities and non-current liabilities.
What are liabilities?
In accounting, liabilities are amounts owed to third parties.
- Current liabilities: These are amounts due to be paid within 12 months, such as accounts payable (amounts you owe suppliers), payroll liabilities and amounts due on short-term business loans, such as a line of credit. Credit card balances and income tax liabilities are current liabilities.
- Long-term liabilities: Amounts due to be paid in a period greater than 12 months, such as long-term loans, and mortgage payments. These liabilities are non-current, but the category is often defined as “long-term” in the balance sheet.
Any loan payments due within a year are current liabilities, regardless of the term of the loan. $10,000 in principal and interest due within 12 months on a five-year loan is posted to current liabilities.
A company’s net worth is defined as equity.
What is equity?
In accounting, equity is total assets less total liabilities. You may also see equity defined as shareholder’s equity .
If you sold all your company assets and used the proceeds to pay off all liabilities, any remaining cash would be considered your equity balance. Equity may include common stock, additional paid in capital and retained earnings.
To illustrate, assume a company starts in business by issuing 1,000 shares of $1 par value common stock. Investors purchase the stock for $5,000. Par value is a dollar amount used to allocate dollars to the common stock category.
Par value of common stock outstanding, multiplied by the number of shares. In this case, the common stock balance is $1,000.
Additional paid in capital
The amount of money invested by shareholders that is greater than the par value of the stock. Additional paid in capital is ($5,000 sales proceeds less $1,000 par value), or $4,000.
The retained earnings balance is calculated as total company earnings (net income) since inception, less all dividends paid to owners since inception. Firms can choose to retain earnings for use in the business, or pay a portion of earnings as a dividend. Dividends reduce the equity balance.
Each accounting transaction must keep the balance sheet formula in balance.
Keeping the accounting equation in balance
Assets on the left side of the accounting equation must stay in balance with liabilities and equity on the right side of the equation:
Assets = liabilities + equity
Assume a firm issues a $10,000 bond and receives cash. The company posts a $10,000 debit to cash (an asset account), and a $10,000 credit to bonds payable (a liability account).
Here is the impact on the equation:
$10,000 increase assets = $10,000 increase liabilities + $0 change equity
Intuit QuickBooks accounting software will ensure each journal entry posted keeps the formula in balance and total debits and credits stay in balance. If you use a bookkeeping service or work with an accountant, they will also keep an eye on this process.
The details in the balance sheet allow the owner to perform financial analysis.
The balance sheet provides a wealth of information about your business. Here are some assessment tools that use balance sheet data.
Liquidity is defined as the ability to generate sufficient current assets to pay current liabilities, such as accounts payable and payroll liabilities. If you can’t generate enough current assets, you may need to borrow money to fund your business operations.
Working capital is frequently used to assess liquidity. The ratio is defined as current assets less current liabilities. Working capital reports the dollar amount of current assets greater than needed to pay current liabilities, and financially healthy companies maintain a positive working capital balance.
Solvency is another term that describes the financial health of a company.
Your firm must be able to generate profits over the long term to purchase assets and to make payments on long-term debt. A business that can meet its obligations is considered to be solvent.
This ratio is calculated as total liabilities /total equity, and this metric tracks increases and decreases in liabilities, as a percentage of equity.
If a company’s accounts payable and long-term debt balances are growing at a much faster rate than equity, the ratio will increase. An increasing ratio may be an indication the firm is taking on too much debt, and cannot make payments on all liabilities.
Accounts receivable turnover ratio
You may run short on cash if your sales are growing and you don’t collect accounts receivable dollars fast enough.
To avoid this problem, many owners analyse the accounts receivable turnover ratio.
(Net credit sales) / (Average accounts receivable)
You’ll note the formula uses sales, which is taken from the income statement.
Here’s an explanation of each component of the formula:
- Credit sales: Sales to customers who don’t pay immediately.
- Net: The net in this case refers to accounts receivable balances that will not be collected. These bad debts are subtracted from the credit sales total.
- Average accounts receivable: Beginning plus ending balance for the period, divided by two. The period of time may be a month or year.
Ideally, a company can increase credit sales, while also minimising accounts receivable. Increasing the turnover ratio means a company’s financial health is improving.
Understanding the balance sheet can help you improve your business results.
Make better decisions
The balance sheet is one of three financial statements that explain your company’s performance. Review your balance sheet each month, and use the analytical tools to assess the financial position of your small business. Use the balance sheet data to make better decisions and to increase profits.