A balance sheet is an important financial statement that summarizes a business’s financial situation. Balance sheets are used to evaluate a company’s performance and ability to meet their financial obligations.
Use this small business guide to balance sheets to gain a better understanding of what a balance sheet is and how to use it. We’ll cover how to create a balance sheet and how it can help you understand your business’s financial situation. Use the links below to navigate the article:
- What is a balance sheet?
- Components of a balance sheet
- Importance of balance sheets and how to use them
- How to read a balance sheet
- How to prepare a balance sheet
A balance sheet is a financial statement that lists a company’s assets, liabilities, and equity. The purpose of a balance sheet is to provide a summary of the entity’s financial position at a specific point in time. As such, the balance sheet may also be referred to as the statement of financial position.
The balance sheet is one of three main financial statements: balance sheet, income statement, and cash flow statement. Like these other financial statements, companies are required by law to generate balance sheets.
Balance sheets may be produced on a monthly, quarterly, or annual basis, depending on your needs. They are valuable business tools that can help you make financial decisions, so it’s useful to refer to them throughout the year.
There are three main components of a balance sheet:
- Assets: Assets are resources owned by the business that can be used to produce economic value. Common business assets include cash, inventory, and equipment. It’s important to note that assets can be divided into several categories, which we’ll cover in more depth below.
- Liabilities: Liabilities are a business’s owed financial obligations. Some common examples of business liabilities are loans and wages. Liabilities are divided into several categories, and we’ll cover the different types of liabilities in more depth below.
- Equity: Equity is the value of the business owners’ interest in the company if all assets were liquidated and all liabilities paid off. To calculate equity, subtract liabilities from assets—as such, equity can be referred to as net assets. Equity can also be referred to as owners’ equity, shareholders’ equity, or stockholders’ equity.
The balance sheet equation is as follows:
Types of assets
Assets fall into several categories. Categorizing assets correctly is important for a clear understanding of your company’s financial position and for proper accounting. Here are the main categories that assets can be distinguished by:
- Liquid vs. non-liquid assets: Liquid assets can be quickly converted to cash, usually within a year or less. Inventory (including raw materials) and cash equivalents are examples of liquid assets. Non-liquid or long-term assets are those that can’t be easily converted into cash, and to do so would cause loss on investment. Land and real estate are good examples of non-liquid assets. Liquid and non-liquid assets can also be referred to as current and fixed assets.
- Tangible vs. intangible assets: Tangible assets are physical assets that the company owns, such as land, buildings, and inventory. Intangible assets are intellectual property that hold future value. This can include assets like your domain name, patents, and trademarks.
- Operating vs. non-operating assets: Operating assets are those that are necessary for regular business operations—this is how most assets you’re familiar with are categorized. Then there are non-operating assets that are non-essential to regular business operations but still generate income or provide return on investment. Unused land and equipment are examples of non-operating assets.
Types of liabilities
Categorizing your company’s liabilities is less complex than classifying assets because liabilities are generally distinguished as either current or non-current:
- Current liabilities: Current liabilities are short-term debts—generally meaning they can be paid off within the year. Rent, utilities, employee pay, and other accounts payable are examples of current liabilities.
- Non-current liabilities: Non-current liabilities are long-term debts—those that cannot be paid off within the year. Deferred tax liabilities, bonds payable, and pension benefits you’ll owe employees are examples of non-current liabilities. Non-current liabilities are often referred to as long-term liabilities.
It’s important to understand current vs. non-current assets because they affect your business differently and are listed separately on the balance sheet.
Importance of balance sheets and how to use them
The balance sheet is meant to give you a clear view of what your business owes and owns. The insights you can gain from the balance sheet—along with other financial statements—allow you to make informed financial decisions as your business grows.
There are several ways to utilize balance sheets, such as:
Determining your business’s ability to meet current financial obligations or defining your working capital. To do this, you will need to know your company’s current ratio and days cash on hand.
- Current ratio is a key financial ratio that will provide insight into whether you can meet your short-term debt payments. Calculate current ratio by dividing current assets by current liabilities: Current ratio = current assets/current liabilities. Preferably, you want your current ratio to be 2.0 or higher.
- Days cash on hand tells you how many days’ worth of expenses you can cover given your current financial position. Days cash on hand = (cash + marketable securities) / ((operating expenses – non-cash expenses) /365)
- Comparing year-over-year or period-over-period. Doing so allows you to see how your financial circumstances have changed and identify areas for opportunity and improvement.
- Determining your business’s net worth if you intend to sell. Not only will you need to know this figure, but potential buyers will want to know—and have the proof to back it up.
- Applying for credit. Lenders will want to verify that you are able to pay back your debts.
- When completing your taxes or providing financial information to regulatory authorities. In some cases, businesses are required to submit their balance sheet and other financial statements for tax purposes.
How to read a balance sheet
Now that you understand the different components that make up the balance sheet, you can use that knowledge to read the balance sheet. Analyzing your balance sheet is fairly straightforward. Here are a few tips to guide you:
- The balance sheet is organized into two sections: the left or topmost section includes assets, and the right or bottom section includes liabilities and equity.
From the top down, you can see:
- Your liquid assets, which allows you to determine your liquidity, or which assets you could turn into cash right now if you needed to.
- Non-liquid assets that you need to hold onto to realize their full value.
- Current liabilities, which allows you to see how much short-term debt you have.
- Non-current liabilities, which allows you to see how much long-term debt you have and where the debt or liability lies.
- Total equity, which allows you to determine the current owners’ equity in the business.
- At the very bottom of the balance sheet, you will see totals for assets and liabilities plus equity. Verifying that these numbers match allows you to confirm that the data in your balance sheet is correct.
How to prepare a balance sheet
So, now you know why you need a balance sheet. But how do you create one? Creating a basic balance sheet can be done in a few steps:
- Determine the dates that will be reflected in the report. Are you going back one month, three months, or the entire last year? This will help you decide which data you need to include.
- Add your assets. You should subtotal liquid and non-liquid assets individually, then total them together at the bottom of the assets section.
- Add liabilities. You should subtotal current and non-current liabilities individually, then total them together at the bottom of the liabilities section.
- Determine equity. This will include stock and retained earnings, among other items.
- Add liabilities and equity together.
- Compare the total assets with the total liabilities and equity. If they match, the balance sheet has been completed correctly.
It’s important to note that the balance sheet should always balance. However, there are instances where it might not because a mistake has been made in the process. If your balance sheet doesn’t balance, you should check your data and calculations.
Automate balance sheet reporting
There is an easier way to produce balance sheets that can avoid mistakes and save the time it takes to make calculations: you can quickly create balance sheets using QuickBooks Online. QuickBooks does the math for you and can quickly turn out accurate balance sheets so you don’t have to spend all that time crunching numbers.
QuickBooks Online automatically tracks and organizes your accounting data, allowing it to generate up-to-date balance sheet reports. You can even set up automated reporting and share your balance sheets with others. Try QuickBooks Online to quickly and accurately create balance sheets and other financial reports.
Instead of struggling with Excel, use our free balance sheet template to simplify the process.
Maintaining your business’s financial health is a key component of long-term success. Utilizing tools like the balance sheet and other financial statements periodically will help you keep your finances in check. Armed with a better understanding of the value of the balance sheet and how to create one, you are now one step closer to better financial management.
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