What is a balance sheet: Definition, components, and how to use one

Balance sheets report a company's assets, liabilities, and equity at a certain time. As a result, these forms assess a business's health, what it owes, and what it owns. In the United States, firms need to maintain a balance sheet for every year they operate. C corporations must also submit one with their tax returns.

On the surface, balance sheets seem like an administrative obligation businesses have to meet. On closer inspection, these forms work with balance sheet software to gauge overall financial performance. To help you, we’ll explain what goes on a balance sheet and how to leverage balance sheets for growth.

• Balance sheet definition
• Balance sheet equation
• Balance sheet components
• How balance sheets work

• Balance sheet limitations
• Analyzing balance sheets
• Using balance sheets for growth

Balance sheet definition and uses

Balance sheets organize company finances on a single document. This financial overview examines a specific point in time. So, while they can’t explain commercial trends, you can compare balance sheets to measure growth over time. 

Balance sheet accounts include entries on:

• Assets: Value the business retains or will receive
• Liabilities: Financial obligations the firm must pay
• Shareholder equity: The amount of money invested by shareholders

What is the purpose of a balance sheet?

Balance sheets measure profitability and keep your finger on the pulse of a firm’s financial health. When paired with other financial statements and accounting software, they offer context for a business’s financial position. Whether you’re facing a downturn or expecting growth, the balance sheet can help explain why.

More specifically, balance sheets provide insight into:

• Liquidity: How much liquid cash your business keeps readily available
• Efficiency: How well your business uses its assets for revenue
• Leverage: The amount of financial risk you can face without jeopardizing your company
• Financial history: A company’s cash flow at a particular moment in time

What is a balance sheet’s main use?

Personal balance sheets and balance sheets for small businesses can record changes in accounts. Additionally, auditors use them to assess financial performance. Auditors may perform an internal or external financial review.

• Executives, employees, and stakeholders tend to issue internal reviews. Generally, internal reviews can look into whether a company succeeds or fails. A business's policies and structure may change based on the audit's results.
• Potential investors and financial regulators perform external audits. Investors use balance sheets to decide if a business warrants their investment. Regulators will compare balance sheets to tax forms and other financial documents.

Balance sheet equation

The equation places assets on one side, liabilities and equity on the other, and ideally sees both sides balancing. Based on the formula, a company pays for its assets by incurring liabilities or borrowing from investors' equity. The balance sheet formula looks like:

assets = liabilities + equity  

If both sides of the balance sheet equation aren’t equal, a business may have financial issues. This formula can help pinpoint the source of the imbalance. 

Balance sheet calculation example

To better understand the balance sheet equation, think of a hypothetical bookstore. The store’s finances include:

• Total assets worth $60,000: $10,000 in cash, $20,000 worth of inventory, and property worth $30,000.
• Total liabilities worth $32,000: $6,000 in taxes payable, and long-term bonds issued for $26,000. 
• Shareholder equity at $28,000: $20,000 in common stock, and $8,000 in retained earnings. 

In this case, the store’s balance sheet balances perfectly. As a result, the store maintained good financial standing the year it wrote this balance sheet.

3 main balance sheet components 

The components of a balance sheet include assets, liabilities, and shareholder equity. Each section reveals more about a company's financial health. By understanding each part of the balance sheet, you can provide the most in-depth analysis.

Assets 

Assets refer to anything a business owns that offers current or future value. The assets section on a balance sheet lists everything your company retains with value. Balance sheets organize assets by liquidity or how easily they convert to cash.

Accountants divide assets into several categories based on their convertibility, physicality, and usage. For example, short-term assets refer to assets a business can quickly cash in. On the other hand, long-term assets cannot easily convert into cash. Others, like operating and tangible assets, help perform vital tasks. 

Examples of assets include:

• Liquid cash
• Securities
• Accounts receivable
• Inventory
• Prepaid expenses
• Property
• Job equipment and tools

Convertibility

Convertibility is the ability of an asset to convert into cash. Based on their convertibility, assets fit into two categories:

• Current assets: Assets you can convert into cash or a cash equivalent in less than a year. Marketable securities, short-term deposits, and stock fit in this category. 
• Fixed (long-term) assets: Assets you cannot easily convert into cash. Fixed assets include trademarks, job equipment, and buildings.

Physical existence

Some assets, like cars and property, take physical form. On the other hand, assets like stock exist intangibly. 

• Tangible assets: Assets you can physically touch, like cars and property. 
• Intangible assets: Assets like brands and trademarks don’t physically exist. 

Usage

Businesses may rely on certain assets for daily operations. You can categorize assets based on the daily use they see:

• Operating assets: You need operating assets to perform core business operations. Operating assets include machinery, tools, and physical locations.
• Non-operating assets: These assets exist as short-term investments and securities that add value outside of regular operations. 

Liabilities

Liabilities refer to debts a company owes to other people and businesses. If assets add value to a firm, liabilities subtract value. Balance sheets list current liabilities in order of their payment due date. Here are a few examples of liabilities: 

• Bills
• Rent on property
• Utilities
• Salaries
• Insurance
• Taxes
• Long-term debts. 

Current or noncurrent

Like assets, you organize liabilities based on their due date. You can organize them into two categories:

• Current liabilities: Debts and obligations you have to fulfill within a year 
• Noncurrent liabilities: Debts you must repay at any point after one year

Shareholder equity 

Shareholder's equity, also called owner's equity, refers to a company's net worth. You can calculate equity in a business by subtracting a business's liabilities from its assets. Balance sheets exist, in part, to calculate equity and share a firm's worth with investors. So, if a business liquidates its assets, owners know how much they will receive. 

Shareholder equity falls into three general categories:

Monetary contributions

Businesses earn a lot of their money through contributions and investments. Typical contributions include:

• Common stock: Securities indicating investment in and ownership of a business
• Preferred shares: Stocks offering a guaranteed dividend instead of rights

Generated earnings

Earnings, or the amount of money a business generates on its own, contribute to shareholder equity. Examples of earnings include:

• Retained earnings: Business income not paid to shareholders as dividends.
• Treasury stock: Company stock bought back from owners.

Donated capital

Shareholder’s equity comes from its own components. The types include:

• Donated income: Donations contribute to equity on financial statements like balance sheets and cash flows.
• Contributed surplus: Also known as additional paid-in capital, this refers to the excess equity capital investors pay when buying stock over the shares' par value.

How do balance sheets work?

Making the most of a balance sheet takes expertise. From composition to analysis, leveraging this document takes time. You can make the most of your balance sheets by following these tips:

1. Appoint accountants to draw up balance sheets. They can find the necessary data on income statements, cash flow statements, and retained earnings forms. Giving them access to bookkeeping software will help ensure accuracy.
2. Adhere to the general sequence of accounts. Generally accepted accounting principles (GAAP) note you should list current assets separately from liabilities. Write asset accounts in descending order of maturity and liabilities in ascending order. Place equity accounts in decreasing order of priority.
3. Ensure the balance sheet is balanced. Balanced means assets will equal liabilities plus equity, equity equals assets minus liabilities, and liabilities will equal assets minus equity. If the sheet isn’t balanced, some details are incorrect.
4. Gauge your company's health. Assuming your balance sheet balances, you can use it to view your financial status. Assuming the sheet doesn’t add up, find the source of the problem. 

Balance sheet limitations

Despite their uses, balance sheets come with a few drawbacks. The main ones to look out for include:

• Limited time frame: Balance sheets only reflect finances at a particular moment. As a result, they can’t always contextualize trends or predict future performance. 
• Limited information: Balance sheets offer more breadth than depth. While you get info on equity, assets, and liabilities, you should combine a balance sheet and income statement for a more dynamic analysis. 
• Threat of misinformation: Executives with access to balance sheets may change them. To ensure all the values are correct, cross reference other documents and check the footnotes for information.

Estimation: Some information on a balance sheet requires estimation. For example, accounts receivable contributes to a company’s assets. However, accounts receivable must estimate what they’ll receive. If their judgment is wrong, this affects your documents.

Example of a balance sheet

To help understand how balance sheets organize your finances, check out the example below:

Balance sheet ratios for improved analysis

Familiarity with your balance sheet will give you an under-the-hood look at company finances. That said, reading the material is only your first step. Accounts should learn how to analyze a balance sheet for the most insight. Thankfully, you can plug balance sheet information into various ratios for financial ratio analysis. 

The most useful balance sheet ratios include:

• Acid-test ratio: The sum of cash, cash equivalents, short-term investments, and current receivables divided by current liabilities. This ratio shows how a company pays its short-term debts by making the most of its liquid assets. A value of one or more means a company can liquidate its assets to pay debts. Some experts refer to the acid-test ratio as the quick ratio. 
• Debt-to-equity ratio: Liabilities divided by owner’s equity. This ratio shows a firm’s ability to generate enough money to fulfill its obligations and debts. A high ratio tells investors and accountants that the company faces late interest payments or even bankruptcy. 
• Current ratio: Current assets divided by current liabilities. A high ratio means the company hoards assets instead of using them. A low ratio means that a company can’t pay its short-term debts. A value between 1.5 and 2 means the business manages its current liabilities and leverages its current assets. 
• Asset turnover ratio: Net sales divided by average total assets. The higher the result, the better a company utilizes its assets to make sales and turn a profit. A low result points to mismanagement, supply issues, or production problems. 
• Inventory turnover ratio: Net sales divided by average inventory at selling price. This ratio shows the number of times a firm sells and replaces its stock in a given period. Higher ratios point to high demand and an ability to make sales.

Factor in additional financial statements

You can overcome a balance sheet’s downsides by pairing it with other forms. By cross-referencing information, you can rely on several documents for a more thorough picture of company finances. Here are the best forms to use with a balance sheet:

• Income statement: A list of revenues and expenses during a specific period. Unlike a balance sheet, it shows how revenue converts into profit. Some accountants call this form a profit and loss statement. 
• Statement of cash flows: A form showing the amount of cash and cash equivalents flowing into and out of a firm. It reveals how changes on a balance sheet result in operating, investing, and financing activities. 
• Tax returns: A tax document reporting tax rates based on income and expenses. Taxes help make up current income tax liabilities on the balance sheet. C corporations must complete a balance sheet as a part of their return. 
• Aging reports: An accounts receivable report on overdue payments. Overdue invoices from a period measure a company's financial health with its balance sheet.

Preparing a balance sheet

You don’t need a license or accreditation to prepare or read a balance sheet. So, the employee responsible for writing one depends on the scale of your business:

• Small businesses may assign the company bookkeeper or have the owner write the sheet. 
• Mid-sized businesses may rely on internal accountants or bookkeepers. If they have the funds, they can hire an external firm.
• Public enterprises must consult public accountants for external balance sheet audits. Their bookkeeping practices will also face higher scrutiny during the review. 

Assessing balance sheets for growth

Balance sheets outline a company’s finances for managers, investors, and regulators. Ultimately, what a balance sheet is matters less than what it can do. By weighing assets against liabilities, reading balance sheets paints a picture of business performance. 

When analyzing your business, understanding balance sheets marks the first step. Combining them with other financial statements will provide the best assessment. From there, you can make changes to improve your business outcomes and boost your ROI. 

Check out our balance sheet software to simplify your financial analysis.