A balance sheet is one of the most helpful tools for a business owner because it shows the real health of the company. It is one of the three financial statements that, all together, can give you a picture of the complete financial situation of your business. (The other two financial statements are: cash flow statement and the profit & loss statement, which sometimes can be called the income statement.)
So let’s take a closer look at what is a balance sheet, and what useful insights you can learn from it as a business owner.
Let’s look at what makes up a balance sheet
A typical balance sheet consists of:
- Owner’s or shareholders’ equity
Assets represent the current (cash, inventory, accounts receivable, temporary investments), fixed (property, land, equipment, vehicles), and sometimes intangible assets (trademarks, goodwill).
Liabilities consist of current (accounts payable, taxes, payroll, credit card payments) and long term liabilities (outstanding loans minus the current payments, mortgages).
Owner’s or shareholders’ equity represents the number of assets remaining available to shareholders after all liabilities have been paid. Shareholders’ equity might include retained earnings, common stock, treasury stock, and paid-in capital.
How the balance sheet is formed
The balance sheet is formed by using a double-entry system of bookkeeping, with all transactions being recorded in at least two different accounts. What this means is that each transaction has both: a corresponding positive and a negative entry. Every entry has its corresponding credit and debit.
The reason behind managing the record-keeping this way is that once all transactions have been recorded, the value of all total assets should in the end match with the total sum of all liabilities and stockholders’ equity, hence, balance.
If something in the equation of Assets = Liability + Shareholders’ equity does not end up matching or balancing, this tells you that you have probably made a mistake in the recording of one or several transactions or entries. See an example of a balance sheet recorded this way here.
So, once you have a well-maintained balance sheet, how exactly can it help you as a business owner?
- It sheds light on risk and returns
One of the biggest benefits of keeping succinct balance sheets comes from their content, namely having both assets and liabilities in one place. Both current and long-term assets speak to a business’ ability to produce cash and keep their operations running. Debts, both short and long-term help prioritize the obligations a business has. Ideally, a thing to strive for would be having more assets than liabilities, which would signal a positive net worth.
When you compare current assets and current liabilities, you can see whether the business is able to cover its immediate obligations. If current liabilities exceed the cash you have available, it shows that your business may need to seek outside working capital. You can also see from a balance sheet when the levels of debt become unsustainable. That happens when there is too much debt on your balance compared to existing current assets and may lead to having to either default on debt payments or declare bankruptcy. A rule of thumb that is good to keep in mind is that if the ratio of assets to liabilities is less than 1 to 1, the company is in danger of bankruptcy, so for you, as a business owner, it will mean that some strategic improvements are necessary in order to stabilize the company’s financial health.
- It builds up your trustworthiness in the eyes of investors and lenders
A great thing about balance sheets is that they allow people outside of your company to very quickly understand your financial condition, without you having to persuade anyone. The numbers will speak for themselves. Most lenders in fact require a balance sheet to determine a business’s financial health and its credit-worthiness. Potential investors may also use it in order to understand where their funding will end up and when they can expect to be repaid (for this it’s important to be able to show your ability to pay your business obligations on time and in full measure).
When you update a balance sheet (important to notice here that it needs to be done on a regular basis and a balance sheet always needs to be titled with a date, as it shows the health of a business for a particular period in time), it shows your ongoing ability to take payments and repay debts. It also shows lenders that you have a track record of successfully managing assets and liabilities. When you apply for loans, you can use a balance sheet to show lenders that you will be very likely to repay your debts on time.
In fact, a carefully maintained balance sheet can be described as a single most potent tool that can be used in order to demonstrate that a business can be trusted.
- It provides you with unique ratios that demonstrate the health of a business at any given time
There are certain techniques that can be used to analyze a balance sheet in greater detail. The main one is financial ratio analysis, which is described in detail here. Ratio analysis in short is a quantitative method of gaining insight into liquidity, profitability, and operational efficiency by comparing its main financial statements such as the income statement and balance sheet.
Among some other ratios that can be used are the debt-to-equity ratio, which can provide a good sense of the company’s financial condition. More information on this ratio can be obtained here. Normally these ratios need more than just the balance sheet, income statement often being necessary as well.
Things like activity ratios mainly focus on current accounts in order to show how well the company manages its operating cycle (this report would include receivables, inventory, and payables).
In general, these and other accepted ratios can provide even more insight into the company’s operational efficiency than a balance sheet alone, but even just having a well-maintained balance sheet as well as a practice of regularly analyzing it can be a great way for business owners of any types of businesses to stay on top of their operations.
It can’t be overstressed that maintaining regularity in producing and analyzing balance sheets is crucial for businesses, as 29% of all businesses fail due to running out of cash – an issue that can be tackled early on when comparing current assets and liabilities. We hope that you will be able to utilize the unique power of balance sheets in order to ensure your business’ growth and success!