Learn to understand what is a balance sheet and get a clear picture of where your company stands financially at a given moment in time.
When it comes to breaking down a company’s financial health, there is nothing more important than analyzing a balance sheet. A balance sheet delivers a general idea about the company’s financial worth. It can help with the following:
- Convincing investors to invest in the company
- Crafting a solid financial strategy
- Assisting employees to achieve productivity goals
So, knowing how to analyze a balance sheet is a critical financial skill for business owners, investors, and even employees. Here you will find everything you need to understand your balance sheet. What is a balance sheet, how important it is, and what are the underlying components—below, you will find answers to all these questions. Keep on reading!
What Is a Balance Sheet?
A balance sheet defines a company or organization’s financial worth at a particular moment, listing out every significant financial detail since your business launched. It tallies your business’s assets, debts or liabilities, and owner’s equity as of a reported date.
Typically, organizations prepare and distribute balance sheets on a monthly, quarterly, or yearly basis. But the frequency of distribution depends on law or company policy.
A balance sheet is known as the most important financial statement as it is a comprehensive document summarizing all your business’s finances.
A quick fact: Do you know that the balance sheet is the only document that lists the owner’s net worth?
Understanding The Balance Sheet Equation
The popular accounting equation is the key to understanding the main components of a balance sheet. Here’s what the equation looks like:
Assets = Liabilities + Owner’s Equity
While this is the most common equation utilized to prepare a balance sheet. Other variants of this equation are also sometimes used to organize information on a balance sheet.
Here are some other forms of this equation that can be incorporated in balance sheet statements:
Liabilities= Assets – Owner’s Equity
Owner’s Equity= Assets – Liabilities
There is one profound rule with the balance sheet: it must balance.
If the assets on the document are not equal to liabilities plus owner’s equity, there is a fat chance that your balance sheet has errors. Typically, errors can either occur due to miscalculations or variations in currency exchange rates.
Understanding the Components
The basic primer that you will find on a balance sheet is composed of three elements: Assets, liabilities, and owner’s equity. Here’s a brief explanation of what’s included in each of these elements.
Assets
A simple definition of assets—the things owned by your business that have a quantifiable value.
It is possible to turn your assets into cash for any financial reason. This process is called liquidation. In the balance sheet, your assets are written as a positive component. They can be further broken down into two categories: long-term and current assets.
Current Assets
The assets you wish to liquidate within a year are called your current assets. The current assets for your company can be:
- Inventory
- Prepaid expenses
- Cash or cash equivalents
- Accounts receivable (short-term payment payable to your company)
- Money in checking accounts
- Short term investments
- Money in transit
Long-term Assets
On the flip side, the assets you do not wish to liquidate within a year are called your long-term assets. long-term assets can include:
- Intellectual property (land or building)
- Long-term investments
- Operational equipment or machinery
- Patents
- Brands
- Trademarks
- Goodwill
Developing a thorough understanding of your company’s assets is extremely important to analyze other documents that communicate your business’s financial health.
Liabilities
After assets, next come your business’s liabilities—the financial obligations payable by your organization to your debtors.
Liabilities are extreme opposites of assets. While assets are financial components that you own, liabilities are something you owe. Since they are debts, liabilities are listed as negative in the balance sheet. Just like assets, there are two categories of liabilities: current liabilities and non-current liabilities.
Current Liabilities
The debts due within one year are your current liabilities. Here are some common examples of current liabilities:
- Unpaid taxes
- Loans due within one year
- Employee wages
- Rent payments
- Utility payments
- Accounts payable
Non-current Liabilities
The long-term financial or legal obligations that are not due within a year are termed as non-current or long-term liabilities. Non-current liabilities can include:
- Bonds payable
- Leases
- Bank loans that you will not pay for another year
- Deferred taxes
- Pensions
Note: apart from the liabilities listed above, your business may also be liable to pay in the form of goods or services.
Owner’s Equity
The money held by the owner of the business after excluding the liabilities is called the owner’s equity. This element is called owner’s equity only when the company is running on sole proprietorship. It is termed as Stockholders’ equity when a company is a corporation.
Equity primarily tallies what is owned by the owners of the company. Here’s what Owner’s equity may typically include:
- Private or public stocks
- Capital aka the money invested into the business
- Company’s retained earnings
Equity can drop in two cases:
- When an owner withdraws money for personal uses
- When a corporation decides to give dividends to stockholders
Typically, owner’s equity is comprised of two things. First, the investments made by other people for some degree of ownership (referred to as shares). The second is the profit made by the company that is retained over time.
Typical Example of a Balance Sheet
Here’s what a typical balance sheet looks like:
Final Words
The facts and figures included in your balance sheet provide a firm understanding of whether your company is struggling or succeeding. Learning to understand a balance sheet is critical for business leaders, potential investors, and people working in corporations.
If you have followed this article from the start till the end, you now know everything there is to know about understanding a balance sheet.
The best way to do everything right is hire a professional like Mi2u Business Support, so you can easily compare your assets with liabilities and ensure that you aren’t falling behind on payments.
They will not only help you compare your previous year’s balance sheet with your current one to analyze your business’s growth, but will provide you any financial services you need.
