A balance sheet shows what a company owns and owes at a specific point in time. Understanding these fundamentals is key for business owners as it helps them gauge their financial health, make informed decisions, and attract investors or lenders.
Imagine being able to see exactly where your business stands financially, helping you plan for the future, secure loans, and attract investors.
That’s where a balance sheet helps you. It provides a snapshot of what your business owns (assets), what it owes (liabilities), and the owner’s equity at a specific point in time.
Did you know?
There are only twelve times a year that we can issue a Balance Sheet according to the accounting gods. That’s the last day of each month.
Even though sole proprietorships and small private companies are not legally required to prepare balance sheets, it is highly beneficial for them to do so.
However, many business owners find such financial statements challenging due to complex terminology, lack of formal financial education, the time constraints of managing daily operations, or a plain fear of numbers. Plus, there is a common misconception that understanding financial statements requires an advanced degree or specialized knowledge, which can discourage small business owners from even attempting to learn the basics.
Let’s break down the components of a balance sheet, explain why it’s vital for your business, and show you how it differs from an income statement. We’ll make it simple and clear, so you can enhance your financial literacy and use this powerful tool to track your company’s financial performance, optimize your finances, and ensure you’re on solid ground.
What is a balance sheet?
A balance sheet is like a financial overview of a company. It tells us exactly how much the company is worth at a specific moment, usually at the end of a month or quarter. This overview includes everything the company owns, called assets, and everything it owes, called liabilities, along with what’s left for the owners, which is called owners’ equity.
Now, why is this financial overview important?
Well, it helps investors and others interested in the company understand its financial health. By comparing what the company owns to what it owes, they can see if it’s in good shape to pay its bills and make investments. They can also see how the company has changed over time, like if it’s growing or not.
Balance sheet components (accounts)
Understanding your balance sheet is impossible without first understanding its components. The balance sheet is divided into three main sections(accounts): assets, liabilities, and equity. Each of these sections contains various accounts within them that give a detailed snapshot of your company’s financial position.
Note: Within these sections, assets and liabilities are further broken down into short-term and long-term categories. This helps paint a clearer picture of what the company owes and owns in both the immediate and distant future.
1- Assets
Assets are what your company owns and are divided into current and non-current assets.
Current assets are highly liquid and can be quickly converted into cash, usually within a year. These include:
- Cash
- Checking and savings account balances
- Marketable securities (like stocks)
- Accounts receivable (money owed by customers)
- Inventory
Non-current assets, also known as fixed assets, are long-term resources that aren’t expected to be converted into cash within the year. These include:
- Long-term securities like bonds
- Real estate
- Machinery and equipment
- Copyrights and patents
At the end of the assets section, the total assets of the company are calculated.
2- Liabilities
Liabilities are what your company owes and are split into current and non-current liabilities.
Current liabilities are short-term debts that your company expects to pay within a year. These include:
- Accounts payable (money owed to suppliers, customers, or lenders)
- Deferred revenue (advance payments from customers for future goods or services)
- Short-term debt (like commercial paper)
- Utility costs
Non-current liabilities are long-term debts that are not due within the next year. These include:
- Long-term loans
- Deferred taxes
- Long-term leases
- Bonds payable (debts that must be repaid to bondholders upon maturity)
The liabilities section ends with the total liabilities of the company.
3- Equity
Equity represents the owners’ claims after all liabilities are paid. It is the amount of money invested in the company by its owners or shareholders. The equity section typically includes:
- Retained earnings: Profits that have been reinvested into the business or distributed to shareholders as dividends.
- Accumulated deficit: When the company has more debt than profit, resulting in negative retained earnings.
- Accumulated other comprehensive income or loss: Income or losses from foreign currency adjustments and unrealized gains or losses from bonds and hedge fund investments.
The equity section concludes with the total equity of the company. Typically, a line shows that the sum of liabilities and equity equals the total assets, ensuring the balance sheet is balanced.
The accounting equation
The three main components of the balance sheet explained above are what make up the fundamental accounting equation:
Assets = Liabilities + Equity
Based on this equation, the balance sheet is split into two sides: On the left, you have everything the company owns, from cash to equipment. And on the right, you’ll find its financial responsibilities, like debts and what’s owed to shareholders.
But here’s where it gets interesting.
Everything on the left has to balance out with everything on the right. It’s like a seesaw – what goes up on one side has to come down on the other. This means that for the balance sheet to accurately reflect the financial position of the business, the total assets must equal the total liabilities plus equity.
So, when you’re looking at a balance sheet, you’re not just staring at a bunch of numbers; you’re decoding how the company handles its money and where it stands financially.
Although the equation you saw above is the most common way to depict balance sheets, it’s not the only way.
Here are a few other ways the same equation might look like:
Owners’ Equity = Assets – Liabilities
OR
Liabilities = Assets – Owners’ Equity
No matter how you see it, the most important thing is that a balance sheet always needs to balance—probably that’s why it’s called a balance sheet.
That means assets must equal liabilities plus owners’ equity. Owners’ equity must equal assets minus liabilities. And liabilities must equal assets minus owners’ equity.
If a balance sheet doesn’t balance, it’s probably because it was prepared incorrectly. Mistakes can happen due to missing data, entering transactions incorrectly, errors in currency exchange rates or inventory levels, miscalculations of equity, or getting depreciation or amortization wrong.
Balance sheet example:
Understanding a real-life balance sheet can help clarify its structure and components. Here’s an example of the balance sheet of a small business.
This balance sheet provides a comprehensive view of the company’s financial health. It starts with current assets, followed by non-current assets, and totals them to give the total assets. Below that, it lists current liabilities and non-current liabilities, concluding with stockholders’ equity.
This structure helps stakeholders understand the business financial stability, liquidity, and overall value.
Why do balance sheets matter?
Understanding a company’s balance sheet is super important, no matter how big or small the company is or what industry it’s in.
Here’s why:
Spotting risks
A balance sheet shows everything a company owns and owes. This helps the company see if it’s borrowed too much money, if its assets can’t easily be turned into cash, or if it has enough money right now to cover its bills.
Getting money
When a company needs a loan or wants investors to put money in, they usually have to show their balance sheet. Lenders and investors want to know if the company is financially healthy and if it can pay back its debts on time.
Making smart moves
Managers use financial ratios, which need numbers from the balance sheet, to check how well the company is doing. By comparing these numbers over time or with other companies, managers can figure out ways to make the company even better.
Keeping employees happy
For employees, knowing their job is safe and their company is doing well is a big deal. When companies share their balance sheets (especially public ones), employees can see if the company has enough money, if it’s managing debts well, and if its financial health matches what they expect from their employer.
So, balance sheets aren’t just pieces of paper with numbers. They’re essential tools for keeping companies on track and making sure everyone involved knows how things are going financially.
Difference between a balance sheet and an income statement
A balance sheet and an income statement (also known as a profit and loss statement) are both essential financial documents, but they serve different purposes and provide different insights into a business’s financial health.
Here’s a clear comparison between the two:
Snapshot vs. performance: the balance sheet provides a snapshot of the company’s financial position at a specific point in time, while the income statement shows the company’s performance over a period.
Content: the balance sheet includes assets, liabilities, and equity; the income statement includes revenues, expenses, and profits or losses.
Purpose: the balance sheet helps assess financial stability and long-term solvency; the income statement helps evaluate profitability and operational efficiency.
Frequency and time frame: balance sheets are typically prepared quarterly or annually and reflect a single date; income statements are prepared monthly, quarterly, and annually and cover a period of time.
The bottom line
Managing a small business is challenging enough without having to worry about the intricacies of bookkeeping. Preparing and analyzing balance sheets and other financial statements can be particularly intimidating if you’re not familiar with accounting. Yet, they are vital for understanding your business’s financial health. A single error can magnify over time, leading to significant issues. That’s why getting it right matters.
A well-maintained balance sheet starts with meticulous bookkeeping. Every transaction documented and categorized accurately builds a solid foundation for reliable financial statements.
While balance sheets are critical, they don’t have to be a source of stress. With CoCountant, you get a designated bookkeeper who will meticulously record every transaction, reconcile your accounts, and provide monthly financial statements, giving you a clear financial snapshot every time.
Don’t let the complexities of bookkeeping weigh you down. Let us handle your books for an irresistibly low monthly price – so you can focus on growing your business.
FAQs
How to read a balance sheet?
Reading a balance sheet involves understanding its basic structure: assets, liabilities, and owner’s equity. Assets are what a company owns, liabilities are what it owes, and owner’s equity is what’s left over for the owners after liabilities are paid. By comparing these sections, you can gauge a company’s financial health.
How often should a balance sheet be prepared?
Balance sheets are typically prepared at the end of an accounting period, which is usually monthly, quarterly, or annually. However, they can be prepared more frequently if needed for financial reporting or decision-making purposes.
What are financial ratios and how are they calculated using a balance sheet?
Financial ratios are tools used to analyze a company’s financial performance and health. They are calculated using numbers from the balance sheet and other financial statements. For example, the debt-to-equity ratio compares a company’s debt (liabilities) to its equity (owner’s equity), giving insight into its leverage and financial risk.