What Is a Balance Sheet and Why Does Your Business Need One?
Need help figuring out what a balance sheet is and how it works? Learn what a balance sheet is, and see examples in this detailed guide.
When you want to know a company's financial health, it helps to look at its balance sheet. But if you've never seen a balance sheet before or don't know how to read one, all you'll see is a collection of impenetrable numbers and strange terms.
You've likely heard about line items and balance-sheet-related terms like working capital, net income, net assets or bonds payable; however, without a cursory understanding of how balance sheets work, these terms can confuse you.
This article will solve that by breaking down balance sheets in detail, explaining what a balance sheet is, and how it works, as well as showing you some balance sheet examples.
What is a balance sheet?
A balance sheet is a detailed financial statement that breaks down all of a company's assets, liabilities, and equity at a specific time, such as the end of a month, the end of a quarter or the end of a year.
You can also make balance sheets for "random" points in time to see how a company is doing at any given moment. No matter when you make one, a balance sheet allows you to evaluate a business's capital structure and determine how profitable it is relative to its expenses.
Think of a balance sheet as a snapshot exploring what a company owns and owes and how much shareholders invest.
Balance sheets, combined with other financial statements, allow investors and business owners to analyze business performance and make the wisest decisions possible.
What are the major components of a balance sheet?
All balance sheets are comprised of three primary sections — here's a detailed breakdown of each:
First, you'll find a breakdown of the company's assets. The assets are everything that a company owns that has a dollar value. More specifically, a company can turn assets into cash at some point.
Current assets can impact a company's financial position and can include the following:
- Money in business checking accounts.
- Physical products and equipment, such as inventory.
- Prepaid expenses.
- Short-term investments.
- Money in transit, like money from invoices.
- Accounts receivable, which is any money owed to a business by its customers.
- Cash equivalents, like stocks, bonds, marketable securities, and foreign currencies.
However, this is by no means a comprehensive list of all total assets, which would also include non-current assets (long-term investments) that a company does not expect to liquify within a given fiscal year.
Additionally, assets can be tangible things, such as business buildings or equipment.
Intangible assets include things like intellectual property, copyrights and trademarks. Note that tangible assets are usually subject to depreciation, so they lose value over time.
Assets may be further broken down into both long-term and short-term assets. You can sell short-term assets relatively quickly, typically in less than a year.
They include the majority of the assets described above. Long-term assets are things like buildings, land, corporate machinery and equipment.
Next on a balance sheet should be liabilities. Liabilities are any of the financial debts or obligations that a company has. Liabilities should be listed by the due date, with the debts or liabilities that are due the soonest listed on top.
Total liabilities can include but are not limited to:
- Taxes owed, including upcoming tax liabilities.
- Accounts payable or money owed to suppliers for items purchased on credit.
- Employee wages for hours already worked.
- Loans you must pay back within a year.
- Credit card debt.
Liabilities can be broken down into current liabilities and non-current liabilities. These are essentially long-term liabilities that don't have to be paid back or settled within the year and can include the following:
- Long-term debt or loans.
- Bonds issued by a company.
You'll need to calculate all liabilities to complete balance sheet accounting equations, practice good bookkeeping and complete or calculate other financial ratios using programs like Excel or others.
Equity is the other significant section of a balance sheet. It's any money currently held by the company. It can be called shareholders' equity, stockholders' equity, owner's equity or similar names. In any case, this balance sheet section should break down what belongs to business owners and the book or monetary value of any investments.
Equity can include:
- Capital in the business — this is how much money the owners have invested into the business.
- Public or private stock.
- Retained earnings, which can be calculated by adding up all revenue minus expenses and distributions.
Note that equity may decrease if an owner takes money out of the company to pay themselves. Equity can also decrease if a corporation issues dividends to shareholders.
All three of these sections combined to tell you what the company owns, what it can turn into cash if it sells those things and what debt obligations it has or the money it owes.
Major balance sheet equation
In a broad sense, every balance sheet's numbers should add up properly according to the following equation:
Assets = liabilities + shareholders' equity
All of the company's remaining assets are the same as its liabilities, added with the equity from its shareholders. The company has to pay for all these things by borrowing money (i.e., liabilities) or by taking value from investors (i.e., issuing shareholder equity).
How does a balance sheet work?
Balance sheets provide clear-cut, mathematically accurate information about a company's finances for a given moment. For instance, if a potential investor wants to know whether a company is a good investment, they may request a balance sheet.
The balance sheet can tell them:
- What the company owns, and what its general profits are.
- What the company owes in terms of debt or liability, which can tell the investor whether the company is a risky investment.
- What the equity in the company is, which tells the potential investor whether investing in the company may provide them with profits later down the road.
Investors can use different ratios and formulas using the numbers on a balance sheet to determine a company's financial well-being. These include debt-to-equity ratios and acid test ratios.
Along with an income statement, an earnings report, and a statement of cash flow, an investor has everything they need to determine the state of a company's finances.
Balance sheets should always balance
Whether you're an investor or business owner, remember that a balance sheet should always "balance." This is where balance sheets get their names.
Put more simply, the company's assets should equal liabilities and shareholder equity.
If for whatever reason, the numbers on a balance sheet do not balance, there are problems, which can include:
- Inaccurate or incorrect data.
- Misplaced data (such as one number being put in a spot where it should be somewhere else).
- Errors with inventory or exchange rate.
- Deliberate falsifications on the part of shareholders, company owners, or accountants.
Why are balance sheets important?
Balance sheets can be essential for every company, regardless of size or operating industry, because of their many benefits.
In short, balance sheets help investors and business executives determine risk. Because it is a comprehensive financial statement, it explores everything that a company owns and everything that the company owes in terms of debt or liability.
In this way, someone looking at a balance sheet can easily assess the following:
- Whether a company has overextended, such as whether it has borrowed too much money.
- Whether the company has enough liquid assets to pay off its debts in the event of liquidation.
- If the company has enough cash on hand to meet current debt obligations.
Balance sheets are also important because they are a prime means to secure investment capital. Business owners usually have to provide balance sheets to potential investors, whether individual investors or large corporations like banks and credit unions. No investor is likely to put money into a business unless they look at a balance sheet first.
In the long term, balance sheets are essential tools that managers can use to determine profitability, liquidity, and other metrics for their company.
Once they have this information, they can make wise decisions, such as paying down company debts instead of expanding during a costly, risky period of time.
What might you need beyond balance sheets?
Balance sheets are excellent financial documents to have and understand, but you can't just use these to understand the company thoroughly. There are some limitations and drawbacks to balance sheets.
For example, balance sheets are static, so they have to be updated regularly. Because of this, an out-of-date balance sheet may not give an accurate picture of a company's financial health. A company might look financially healthy on one day and appear to be heading toward insolvency on another.
Because of this, it's a good idea for investors, business owners, and managers to also acquire cash flow statements, income sheets, and other financial documents if they want to determine a company's holistic, comprehensive health.
Balance sheet example
The best way to truly grasp balance sheets is to look at concrete examples. While you can create balance sheets using Microsoft Word and other word processors, you can also check out premade sample balance sheets from Accounting Coach.
These example balance sheets include fake corporations with real numbers and equations. They also include balance sheets in different forms, such as account form balance sheets and report form balance sheets.
Check out these example balance sheets to see how these documents should look when correctly filled out. Try filling in a balance sheet template like your company's balance sheet to get a practice picture of your company's financial position.
So, what are the takeaways about balance sheets?
Balance sheets are relatively easy to scan once you know what to look for.
More importantly, balance sheets can tell you a lot about the company's financial health and help you make wise business or investment decisions depending on your goals.
Running a business means more than just reading your balance sheet accurately, though.
Interested in learning more about professional finances? Check out Entrepreneur's other guides and financial resources today.