Why do we need to understand a Balance Sheet?
A Balance Sheet (also known as Statement of Financial Position) is one of the three primary financial statements (along with the income statement and statement of cash flows) showing the company’s financial condition at a specific point in time. Unlike the income statement which shows the performance of a company over a period of time, the Balance Sheet shows the business’s current financial position.
A Balance Sheet enables you to analyze and evaluate the financial health of your business and share this information with others, such as your current or potential investors, lenders, and other persons outside the business who need to stay informed about the business’s financial affairs.
Business managers and anyone thinking of becoming an entrepreneur and starting a business should know how to understand financial statements and the accounting methods used to prepare them. With a Balance Sheet, you can analyze the liquidity (capacity to pay currently maturing obligations) and solvency (capacity to meet long-term financial commitments) of your company on a regular basis.
The sections of a Balance Sheet
A Balance Sheet contains three main sections, namely assets, liabilities and equity.
Assets are resources acquired and operated by your company. An asset can be either of these:
- Something you own; for example, money, goods, equipment, buildings, brand names, shares in other companies, etc.;
- Something you’re owed by someone else; for example, loaned money.
Liabilities are a company’s debts or obligations. Examples of liabilities are payables to suppliers (accounts payable), banks and other financial institutions (e.g. notes and mortgage payable), and incurred expenses (accrued expenses).
Equity (or Owner’s Equity) reflects the amount the owner has invested in the firm. There are two sources of Owner’s Equity:
- The amount of money invested by the shareholders
- The amount retained from profits (called Retained Earnings). It’s a cumulative amount of profit over the years that hasn’t been distributed to the shareholders.
The structure of a Balance Sheet
When you first see this financial statement, you may think it’s complex and requires a mathematical genius to figure out its intricacies. It’s far less daunting to discern, especially once you know what you’re looking at. Actually, a Balance Sheet is just a table listing someone’s assets, liabilities and equity along with their values at a particular point in time.
As we’ve mentioned earlier, a Balance Sheet contains three major elements – assets, liabilities and equity. These three elements are the general sections of the Balance Sheet.
Assets are classified as either current or non-current assets. In a Balance Sheet, current assets are normally (but not mandatory) placed first before non-current assets.
Current assets are very liquid, meaning they can be easily converted to cash when the company decides to liquidate its assets. Examples of current assets include cash (and cash equivalents), trading securities, accounts receivable, inventory, and supplies.
Non-current assets are assets that have longer lives. They can’t be easily converted to cash like current assets. These include property, plant and equipment and intangible assets (e.g. trademarks and patents).
Like assets, liabilities are classified as current and non-current liabilities.
Current liabilities are debts that are due to be settled within an operating cycle (normally, twelve months). Their maturity is near which is why they are classified as current. Examples are accounts payable, accrued expenses, and current portion of long term debts.
Non-current liabilities are long-term liabilities. They are due to be settled within more than a year. Examples of non-current liabilities are bonds payable and mortgage payable. They are usually paid for a longer period of time.
What is a Balance Sheet equation?
There is a very intuitive method that many business owners and investors use to calculate the value of a company’s equity. They use the following equation:
Owner’s Equity = Assets - Liabilities
Owner’s equity is the amount left over after all liabilities are deducted from all assets. Our equation being a regular math equation, we can isolate its Assets part to receive the following accounting equation that a Balance Sheet represents:
Assets = Liabilities + Owner’s Equity
The total sum of the company’s assets equals the value of the company’s liabilities and owner’s equity.
So, a Balance Sheet is separated on two sides, with assets on one side and liabilities and owner’s equity on the other.
A Balance Sheet is so named because its two sides always add up to the same amount. This unbreakable formula is always, always true.
In other words, a Balance Sheet shows two sides of the business: assets, which are the economic resources owned and being used in the business, and liabilities + owner’s equity, which are the sources of these assets.
Forms of a Balance Sheet presentation
Generally, there are two forms on how to present a Balance Sheet:
The traditional form, called an account form, presents two main columns. The column on the left lists down all the assets and their values, and the column on the right does the same with liabilities and equity. The final values of these columns should be the same, and once they are, a balance is seen.
Assets and liabilities are listed in a particular order. Speaking of assets, they are listed in order of how liquid they are, whereas liabilities are listed in order of how they will be paid.
The report form, which presents the assets above, liabilities and stockholder’s equity below.
There are no legal requirements as to which to use and the company may use either of the two. Both types of format are widely used.
The importance of a Balance Sheet: Understanding liquidity and solvency ratios
A Balance Sheet is vital to decision-makers, especially to investors and creditors, as it contains information about the financial health of a company. Liquidity and solvency are indicators of how financially stable a company is. Most of the information needed to compute liquidity and solvency ratios are found on the face of a Balance Sheet.
The Current Ratio indicates whether the enterprise has sufficient assets that can be used to repay short-term obligations. The formula is fairly simple:
Current Ratio = Current Assets / Current Liabilities
This is a ratio that a lender will often use. A current ratio that is above 1 is acceptable. However, it’s advisable that a current ratio is 1.5 or above to perfectly finance the other needs of the company. It’s not advisable though to have a current ratio that is too high because it means the company isn’t using its excess cash to earn other income.
The Quick Ratio, also known as Acid-Test Ratio, measures the company’s ability to pay current liabilities using its quick assets. Quick assets are the most liquid assets. They include only cash, accounts receivable and trading securities. The formula is:
Quick Ratio = Quick Assets / Current Liabilities
There are two solvency ratios that give the degree of financial leverage – the debt to equity and debt to assets ratios.
Debt to Equity Ratio = Total Debt / Total Equity
Debt to Assets Ratio= Total Debt / Total Assets
Both ratios provide information about the company’s assets and equity relative to short and long term debts.
When do I need a Balance Sheet?
A Balance Sheet is a financial reporting document that you can use while looking for funding for your business. When you present it to a potential lender or investor, they will be able to do a quick analysis of your financial situation, and this will make it easier for them to arrive at a quick decision. This is because a Balance Sheet provides information that determines whether you’re in debt or not, as well as the total value of the assets for your business.
As an entrepreneur, it’s recommended that you look through your Balance Sheet at least once every month, especially that the financial statements generation process doesn’t require a lot of time since you’re using modern accounting software.
A Balance Sheet is an excellent tool for helping you stay on top of your finances. With a Balance Sheet, you can ensure that your liabilities don’t exceed your assets, thus avoiding financial issues.
You will find that the Balance Sheet isn’t a stand-alone document, although it’s a vital one. It’s usually interpreted together with the income statement and cash flow statement. Together, these three statements paint a comprehensive financial picture. As your business grows, your balance sheet will also increase in its overall complexity.
Keep in mind that this document is important, while ignoring the information that it provides for your business could be dangerously. Take advantage of your balance sheet and watch your business prosper once you begin making smarter, better-informed decisions.