A balance sheet is a financial statement that lists a company’s assets, liabilities, and equity balances as of a specific date. The balance sheet is connected to a firm’s income statement, and statement of cash flows, which are two other important financial reports.
Your company’s balance sheet is more than simply a financial statement. It’s a powerful tool that you can use to make better financial decisions to reduce expenses, increase profits, and collect cash faster.
This article explains the components of the balance sheet and provides a comprehensive example of a firm’s balance sheet. You’ll also learn how the balance sheet is connected to other financial statements, and you’ll review some key balance sheet metrics to improve your business results.
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Balance Sheet Components
A balance sheet is important, as it provides the owner a snapshot of what they own, the balances they owe and how much their business is worth. To analyze and use the balance sheet, you need to first understand the balance sheet components:
The Components of a Balance Sheet
The three components of the balance sheet are driven by the balance sheet formula:
Assets – liabilities = equity
A balance sheet provides detail for each of these categories:
- Assets: Assets are defined as resources that are used to generate revenue (sales) and profits in the business. An asset may be tangible, such as a vehicle, or intangible, such as a patent or other intellectual property.
- Liabilities: Liabilities represent amounts owed to other parties, including accounts payable and long-term debt.
- Equity: Equity (also referred to as stockholder’s equity) is the difference between assets and liabilities, and equity includes common stock, additional paid-in capital, and retained earnings. The equity balance is the true value of a business.
The balance sheet formula must stay in balance, regardless of the number of transactions posted, or the dollar amount of accounting activity.
An Example Transaction
Here’s a transaction that illustrates how the balance sheet formula is kept in balance.
Assume, that a firm sells $20,000 in products to a customer and that the customer pays $5,000 when the products are received. The accountant would post this journal entry:
Accounts receivable is an asset account, and the balance represents money that is owed by clients. Both accounts receivable and cash are asset accounts, and they are increased with a debit entry.
The firm also posts revenue, which is increased with a credit. Revenue less expenses equals net income, and net income is posted to equity. As a result, an increase in revenue also increases the equity account.
Here is the transaction’s impact on the balance sheet equation:
$20,000 increase assets – No change liabilities = $20,000 increase equity
The journal entry keeps the balance sheet equation in balance, and all journal entries must comply with this requirement. Fortunately, accounting software packages require you to post balanced journal entries.
Balance Sheet: In Detail
To effectively use the balance sheet to make informed business decisions, you need to understand the accounts that are typically included in a balance sheet. To explain this concept, assume that Joe owns Reliable Plumbing, a residential and commercial plumbing company that generates $12 million in annual sales.
Current vs. Non-Current
The balance sheet classifies assets and liabilities are either current or non-current. A current asset represents cash, or an asset that will be converted into cash within 12 months. Accounts receivable balances and inventory, for example, are current assets. Fixed assets, such as machinery and equipment used in a business, are non-current assets, because they will be used for years to generate revenue.
Accounts payable are bills you must pay within 12 months, and they are considered current liabilities. Long-term debts, however, are non-current liabilities. To properly analyze your balance sheet results, you need to classify your assets and liabilities as current or non-current.
A Complete Balance Sheet
Here is Reliable Plumbing’s balance sheet as of 9/30/2018, with account balances listed:
|Reliable Plumbing Balance Sheet|
|Total current assets||2,550,000|
|Total non- current assets||4,650,000|
|Total current liabilities||1,200,000|
|Total noncurrent liabilities||1,500,000|
|Additional paid-in capital||900,000|
Note the following:
- Assets: Just about anything you use to make money in the business is an asset, and assets are posted to the balance sheet. Reliable Plumbing, for example, owns plumbing trucks, equipment and a warehouse. Assets are what the business owns.
- Liabilities: This section of the balance sheet lists bills that are owed and long-term debts. Liabilities include salaries owed, utility bills due and a long-term debt balance. Liabilities are what the business owes.
- Equity: Assets less liabilities equals the equity balance. As an example, Reliable Plumbing, has $7.2 million in assets and liabilities totaling $2.7 million. Assume that Joe sells all of his assets for cash, and then uses that pile of cash to pay off every liability. Any money that remains is the firm’s equity. Reliable’s equity is ($7,200,000 – $2,700,000), or $4,500,000. Equity represents what the business is worth.
There are some unusual accounts in the equity section. When Joe sells ownership in his business to investors, he increases the cash account and also increases common stock and additional paid-in capital.
You’ll also note a large balance in retained earnings, which represents the total company earnings since the company began, less dividends paid to shareholders. Joe has the option of paying shareholders a dividend, or retaining earnings for use in the business.
The starting point for using the balance sheet is to understand assets, liabilities and equity. Once you’re comfortable with the accounts, you can use the balance sheet data to make decisions and improve your company results.
Make Better Decisions
As a business owner, you may not be using the information in the balance sheet to make better decisions, and that’s not unusual. Owners have to manage dozens of tasks, and financial analysis may not be one of them. Joe, the owner of Reliable Plumbing, is one of those owners.
Here’s a discussion of Joe’s current process for using balance sheet information, and how he can use the data to make better financial decisions.
The Current Process
Joe’s business is well established and his firm has a great reputation in the community, but managing a growing company is requiring more of Joe’s time. His gut tells him that unless he spends more time analyzing his financial results, he’s going to make some poor business decisions.
Joe’s current method of financial analysis is pretty basic. At the end of each month, he generates an income statement and takes a look at his net income or profit. Joe divides net income by sales to calculate the company’s profit margin. Reliable Plumbing typically operates at a 15% profit margin, which means that the firm generates 15 cents of profit for every dollar in sales.
Joe computes the profit margin each month and compares the result to his average profit margin for the year. His quick analysis gives him a sense of each month’s level of profit.
After reviewing profitability, Joe takes a look at the cash balance by generating a balance sheet. To get an accurate look at cash, he reconciles the bank account and compares the reconciled cash balance to his average cash balances for the past 12 months. If the cash balance seems low, he checks accounts receivable to see if any large receivable balances need to be collected quickly.
Once he checks profit for the month and reviews his cash balance, Joe doesn’t perform any other analysis.
A Better Approach
To get the most out of your accounting data, you need to understand the connections between the balance sheet and other financial reports. These connections will help you understand your company’s cash activity, and how to manage cash more effectively. Finally, smart managers use financial ratios to track company results, and you should find an accountant who can help you understand ratios.
Important Connections: Balance Sheet, Income Statement, and Statement of Cash Flows
It can be really difficult for a business owner to step back, take a breath and look at the big picture. One big picture concept that’s important to understand is the connection between the three basic financial reports. If you’re clear about how the financial statements connect, you can make better decisions.
Consider the income statement and the balance sheet. Reliable Plumbing earned a 15% profit margin on $12 million in sales, or $1.8 million in net income. Net income from the income statement increases the equity balance in the balance sheet. When Joe prints his month-end balance sheet, the $4,500,000 equity balance includes the month’s $1.8 million in profit. That makes sense because earning a profit makes the company more valuable, and equity reports the company’s value in dollars.
In addition, the cash balance in the balance sheet is the ending balance in the statement of cash flows. The cash flow statement essentially takes the company checkbook and assigns cash inflows and outflows into these categories:
- Cash activity from financing: This category accounts for raising money to operate the business and paying it back. Issuing common stock is a cash inflow and repaying a loan is a cash outflow.
- Cash activity from investing: Investing refers to buying and selling assets. If Reliable pays cash for a truck, that’s a cash outflow, and if the company sells some equipment for cash, it’s recorded as a cash inflow.
- Cash activity from operations: This is the “everything else” category, because every cash transaction that is not related to financing or investing is posted here. Not surprisingly, this is the category that accounts for most of Reliable’s cash activity. Paying employees and collecting money from customers are posted here.
The formula for the cash flow statement is:
(Beginning cash balance) plus or minus (cash inflows and outflows for the month) equals (ending cash balance). The ending cash balance is also the cash balance on the balance sheet.
At the end of each month, take the balance sheet, income statement, and the statement of cash flows and lay all three reports in front of you. Look at the connections discussed above, and you’ll have a much clearer picture of your business results.
Using Financial Analysis to Increase Cash Flow
For many owners, the most important metric for their business is the amount of cash they need to operate each month. That may be more important to the owner than profit, since no company can operate without sufficient cash. If that’s what keeps you up a night, you can do something about it using financial statement analysis.
Think about it this way: if Reliable Plumbing generates a 15% profit on every dollar sold, which also means that 85% of every dollar sold generates an expense. $12 million in sales for the year means that Reliable incurs $10.2 million in expenses. And those expenses have to be paid in cash, either this month or sometime down the road.
A business can generate more cash to operate by reducing the account balances that tie up a great deal of cash:
- Accounts receivable
Accounts receivable represents money owed by clients, and your inventory balance is the dollar amount of items that you buy for resale. Reliable Plumbing carries a large balance of parts and supplies in inventory, which are used to perform plumbing jobs
Joe can take several steps to increase cash flow. He can offer discounts to clients who pay quickly, and Reliable Plumbing can insist that all customers pay a 20% deposit before any work is performed. The company should also have a formal process for collections, including phone calls and emails to clients who have not paid their invoices.
These steps will reduce the account receivable balance and increase cash. QuickBooks Online can help businesses track unpaid invoices, remind customers that a balance is due, and take payments via credit card and bank transfer.
Reliable should also take a hard look at the dollar amount of inventory on hand. If Joe’s suppliers can ship inventory items faster, for example, the company can reduce the inventory levels and still meet customer needs. If a supplier can get orders to Reliable in five days rather than ten days, for example, the plumbing company can carry less inventory and simply order more often.
The balance sheet is used to generate many financial ratios to make business decisions, and two important concepts for analysis are liquidity and solvency. Liquidity measures a firm’s ability to produce enough current assets to pay current liabilities in the short term.
The term solvency, on the other hand, refers to a company’s ability to generate enough sales and profits to purchase expensive assets and pay down debt over the long term. Financially healthy businesses must address both liquidity and solvency.
There are two resources you can use to understand financial ratios. First, accounting software packages can automatically generate financial ratios, using your balance sheet and other financial statement data. You should also work with an accountant, who can help you understand the ratios, and what each ratio tells you about your business.
More Than Just a Report
The balance sheet is far more than a report of assets, liabilities, and equity balances. Successful business owners use balance sheet data to reduce costs, increase cash inflows and produce better financial results. Invest the time to understand the balance sheet, and why this report is so useful.