There are a few tools of the trade that business owners and entrepreneurs rely on. Accounting software, a high-speed Internet connection, and balance sheets. Balance sheets provide a snapshot of a business’ financial health by displaying key line items that all business owners should know. For a quick definition, a balance sheet is monthly, quarterly, or annual snapshot of a company’s net worth.
That seems important. Below we’ll run through how to create a balance sheet, how to read a balance sheet and how to format a balance sheet. But first, what is a balance sheet?
What is a Balance Sheet?
A balance sheet is a picture of a company’s net worth at a given time, such as the end of the year. It reflects the company’s assets, liabilities and owner’s equity. It’s important to create and review this financial statement to track the growth (or contraction) of your business.
In the multitude of business documents, the balance sheet differs from an income statement which reports sales and expenses during a specific time; and a cash flow statement that examines the flow of cash in and out of your business.
A balance sheet rises above them all to provide a complete picture of your company’s financial health. As a result, it has a robust amount of data. Here are the components that make up a balance sheet:
- Assets – What your business owns
- Liabilities – What your business owes
- Net Worth – Your business’ net worth during a set timeframe. This figure is also known as owner’s equity.
Let’s take a look at each of these to give you a better understanding of how to make a balance sheet.
Components of a Balance Sheet
While assets and liabilities are key to a balance sheet, the most important part is the equations that figure those numbers.
The basic equation of any balance sheet is:
Assets = Liabilities + Owner’s Equity
Owner’s Equity = Assets – Liabilities
As you can see, these equations all feature the basic elements of a balance sheet. Here’s an overview of what these components are, so you can format your balance sheet.
Assets include a summary of what your business owns and is generally divided into three categories: Current Assets, Fixed Assets, and Other Assets.
- Current (or Liquid) Assets: This is cash and assets that will likely turn into cash during the current business year. It’s what you generally use to pay operating costs.
- Cash: The total amount of money on hand (your most liquid asset).
- Accounts Receivable: The amount that your customers owe you after buying your goods or services.
Less: Reserve for Bad Debts: This is the total amount you expect to write off when customers default (generally calculated based on bad debts during previous reporting periods).
- Inventory: If you sell products, you will likely have inventory. This line item represents the total amount that you have on hand at that particular time. If this number is growing faster than your revenue, you may not be managing your inventory efficiently.
- Prepaid Expenses: Expenses you have paid in advance, such as a year’s worth of insurance.
- Securities: Securities include money-market accounts and other investments that you plan to sell within the year.
- Notes Receivable: This is the amount owed for goods or services that isn’t paid on a regular schedule.
- Fixed Assets: Fixed assets include vehicles, furnishings, equipment, buildings, and land used for the business and that will not be sold. Generally, these assets decrease in value over time. For that reason, depreciation is factored into your total.
Less: Accumulated Depreciation: Depreciation is the amount allowed for wear and tear, based on an established formula.
- Other Assets: These are things you own that are neither fixed nor current assets that can be converted to cash. Intangible assets, which have no physical manifestation, such as goodwill, patents, copyrights, and trademarks fall into this category.
- Total Assets: This is the total cash value of all the assets that your business owns. This amount should remain higher than your total debts in order for the company to prosper.
Liabilities are debts that the business owes. They fall into two categories: Current and long-term liabilities.
- Current Liabilities: These are amounts due to be paid within a year, such as accounts payable (amounts you owe suppliers and employees), sales and payroll taxes, income taxes, and amounts due on short-term business loans, such as a line of credit.
- Long-Term Liabilities: These are amounts due over a period longer than a year, such as long-term loans, leases or mortgages, deferred taxes, and future employee benefits.
- Total Liabilities: This is the total value of all the company’s debts. A healthy business will usually show a number here that is less than its total assets.
Also known as Capital or Net Worth, this amount represents what would be left for the owner(s) if all the company assets were sold and total liabilities were paid. A company with positive equity means that business owners have the option of acquiring capital by selling part of their business through equity, stocks and/or dividends.
In a sole proprietorship, this is called the “Owner’s Equity”; in a corporation, this is called “Stockholder’s Equity,” and it can include common stock, preferred stock, paid-in capital, retained earnings, etc.
“Equity” may include:
- Opening Balance Equity: The initial investment into the company
- Capital Stock: The common and preferred stock a company issues
- Dividends Paid: Profits paid out to shareholders by a company (applies to corporations)
- Owner’s Draw: Portion of the revenue used by company’s owner (applies to sole proprietorships)
- Retained Earnings: The sum of a company’s consecutive earnings since it began
- Net Profit to Date: This is your total sales revenue, after expenses, for the current year. The amount is found on the company’s income statement (bottom line).
Together, your company’s liabilities and owner’s equity must equal your total assets for the balance sheet to be considered “balanced.”
Why You Need a Balance Sheet
A balance sheet is the quickest way to understand the financial health of your business. Knowing this information provides you with the data you need to make decisions regarding the growth or decline of your business and can inform you about the strengths, weaknesses, and trends of your business for long-term success.
For example, Michael is a small business owner who is looking to make an investment to grow his company. Using balance sheets, he can compare numbers from Q1 and Q3 and determine if he has the capital to invest. The balance sheet also allows Michael to look for trends (i.e. sales number fluctuations, increases in liability or decreases in assets), and determine if his business is poised for growth.
The value of your assets minus your liabilities will result in an estimation of the value of your company’s capital. If this equation results in negative net worth, this can be dangerous for a small business; it will make it difficult to secure financing, which can be troubling for a company whose expenses are already eclipsing its profits.
How to Create a Balance Sheet
With all of these elements and numbers, you must collect, you might be pleased to know that there are a variety of resources that can provide a balance sheet template for your use. This way the actual format of the balance sheet isn’t something you need to worry about; just gathering all the data to fill it in.
Most accounting software programs, including QuickBooks Online, will have an available template/report for balance sheets.
This article is another resource that offers a free balance sheet template and further details on how to figure your assets, liabilities and owner’s equity to ensure accurate figures you can rely on.