A balance sheet is a financial statement used by a business for insight into its financial standing and overall value. It records a summary of the business’s finances, including the assets, liabilities, and owner’s equity.
Balance sheets are important accounting tools for small businesses because they not only provide a snapshot of a business’s financial balances at a given point in time but can serve as key indicators of potential growth or decline. Below, we’ll delve into how to read and prepare a balance sheet and identify the components involved so you can maintain better accuracy when recording and calculating your business’s finances.
- A balance sheet provides a general overview of a business’s value and financial standing and is essentially a summary of all assets, liabilities, and equity.
- Assets are placed on the left side of the balance sheet, while liabilities and equity are placed on the right side. The amounts on each side of the balance sheet should be equal and balanced out.
- Small business owners can use and analyze balance sheets for insights, such as net worth, growth and progress, and creditworthiness for lenders.
What Is a Balance Sheet?
A balance sheet is a financial statement used by businesses to keep track of finances and show their value within a specific period of time. It contains the assets and liabilities of a business, as well as equity. Assets are items of value owned by the business, and liabilities are the debts they owe. Equity belongs to the business owners and is equal to the amount left after assets and liabilities are considered.
Balance sheets can be created on a monthly, quarterly, or yearly basis. These statements are important as they offer many insights to many stakeholders and considerations. An example might be a company's financial position and ability to service its loans, which is useful for lenders when considering extending credit. A balance sheet can also provide information to investors about whether or not to invest in the business. It can be used in estate, legal, and tax matters.
For the business itself, a balance sheet can, for example, help an owner figure out how much cash may be needed to pay off liabilities or how much capital is tied up in investments. This can be especially beneficial for startups, entrepreneurs, and other small business owners looking to expand.
What’s Included in a Balance Sheet?
To create a balance sheet, you’ll need to collect all receipts, invoices, and other financial documents to record your business’s finances. Using a chart, you’ll then record this data in one of the three sections: assets, liabilities, or equity.
Assets are items of value that the business owns. Some assets can increase the overall value of the business as these are items that can be sold or used to make products or deliver services that can be sold.
Assets are classified as tangible and intangible assets. Tangible assets are physical objects that can also be categorized as fixed assets, meaning they are not for sale but rather used for operational purposes. Intangible assets, meanwhile, are not physical objects but concepts or ideas of value, such as intellectual property.
Some examples of small business assets include:
- Accounts receivable
On a balance sheet, assets are listed on the left side and are further divided into current assets and noncurrent assets. In the current assets section, you would include all the assets your business can expect to turn into cash within the current period. In the non-current assets, you would include all other assets that bring value to the business but aren't expected to be sold or to bring in a cash value within the year.
Liabilities are essentially the debts of the business. This is what the business owes to other businesses, employees, and even customers. Liabilities are listed on the right side of the balance sheet, opposite of the assets. Some examples of liabilities include:
- Accounts payable
- Bank loans
- Goods owed to customers
Like assets, liabilities are divided into two categories: current liabilities and noncurrent liabilities. Current liabilities are the debts that are owed and must be paid within the year, such as accounts payable. Non-current liabilities are debts that are considered long-term and don’t need to be paid out fully within the year, such as loans.
Equity is considered the net worth of the business. On a balance sheet, it is listed after liabilities and represents the amount that would belong to the owners of the business if all assets were used to pay off all liabilities. It may also be referred to as shareholders’ equity or owner’s equity.
While the term “shareholders’ equity” is primarily used for corporations, small business owners like sole proprietors without investors should refer to this as simply “owner’s equity.” The main difference between these terms is whether investors hold a portion of the business.
How To Prepare Your Balance Sheet
Once you understand what goes into a balance sheet, you can begin to create it. There are many templates and software programs available that provide the basic structure, making it easy for small business owners to get started. Here are a few basic steps to take to prepare your balance sheet:
- Determine whether you’ll be reporting for the month, quarter, or year.
- Gather all financial documents, such as receipts and invoices, pertaining to your business’s assets and liabilities.
- Fill in all amounts of assets and liabilities, with assets on the left and liabilities on the right.
- Determine retained earnings or equity.
- Make sure both sides balance out.
Understanding Your Small Business Balance Sheet
After you fill in your balance sheet with all the necessary financial data, you can begin to analyze that data. Balance sheets offer many insights, including a company’s net worth, areas requiring more organization, progress made over time, and the ability to show your business is worthy to lenders. You can use your balance sheet to calculate key ratios, which can help you to understand your business’s financial standing. Here are some examples:
- Debt Ratio: The debt ratio is used to determine the financial standing by determining debt using the formula: Debt Ratio = Total Liabilities ÷ Total Assets
- Working Capital: Working capital refers to the funds used to cover operating costs and can be calculated using this formula: Working Capital = Current Assets - Current Liabilities
- Debt-to-Equity Ratio: The debt-to-equity ratio shows a business’s leverage regarding its capital and whether the majority of it is debt or shareholders’ equity. It is calculated with the formula: Debt/Equity Ratio = Total Liabilities ÷ Total Equity
Frequently Asked Questions (FAQs)
What is a strong balance sheet?
A strong balance sheet shows a company is financially stable. This generally means the business has more assets than liabilities and can cover all expenses expected within that year. A strong balance sheet shows the ability to meet the needs of customers and expenditures for business growth.
Does a small business have to have a balance sheet?
Balance sheets are not necessarily a requirement for you to run your business. However, most business owners should create and maintain these statements to help them prioritize financial obligations while being able to show where they stand financially to any potential lenders or investors.
What is the difference between an income sheet and a balance sheet?
Income statements and balance sheets are both financial statements that show a business’s standing but differ in the layout and in the way they’re used. A balance sheet shows a company’s assets, liabilities, and equity for a specific point in time while an income statement shows revenue and expenses over a period of time.