Business owners know the importance of various financial statements and their role in helping drive business decisions, especially profit and loss statements or income statements. But on the other hand, balance sheets remain a mystery to many users. As a result, many overlook the important information provided by the balance sheet.
Within this article, we’ll take a further look into the balance sheet and its components, its importance, and how to draft one.
What is a balance sheet?
The balance sheet is a financial statement that depicts an organization’s book value as calculated by subtracting all liabilities and shareholder equity from total assets. Simply put, the balance sheet is a snapshot of company performance for external and internal analysis. Investors from within and outside the company will see current, past, and future information concerning the stability of the company.
Why is a balance sheet important?
The balance sheet becomes an essential tool for investors to determine the potential future of an organization and make investment decisions. Information housed in this financial statement will point internal and external investors in the right direction. Essentially, the balance sheet determines risk for potential investors.
Who prepares a business’ balance sheet?
In a small business, the balance sheet will likely get prepared by the owner or a bookkeeper. Larger corporations will have the accounting department put together all financial statements, which get reviewed by an external auditor.
What are the parts of a balance sheet?
The balance sheet has three sections: assets, liabilities, and shareholders’ equity. Unsurprisingly, the sheet has to balance with assets equal to the amount of liabilities and shareholders’ equity.
Section 1. Assets
Liquidity determines the order in which accounts get listed under the assets section, with the more liquid at the top. However, the general order is as follows:
- Cash or “cash equivalents”: the most liquid of accounts such as actual cash, treasury bills, or short-term certificates of deposit.
- Marketable securities: equity and debt securities that have a current liquid market.
- Accounts receivable: another way to explain this is money owed to the company from customers.
- Inventory: as the name suggests, anything the company keeps on hand.
- Prepaid expenses: services paid for upfront, such as insurance and advertising.
Section 2. Liabilities
This section lists debts the company has to a debtor, which are classified into two sections:
- Current liabilities: also known as short-term liabilities. These accounts are to get paid within one year and include accounts payable.
- Non-current liabilities: known as long-term liabilities. The company does not pay these off within a year, which means they are a long-term obligation, such as leases and bonds payable.
Section 3. Shareholders’ equity
Typically speaking, this section is the net worth of the company. It shows the amount of funds left if all assets were sold and liabilities paid.
Example of a balance sheet
|ABC Manufacturing Company|
|Date: December 31, 2022|
|Total current assets||$27,000.00||$39,000.00|
|Property & equipment||$250,000.00||$350,000.00|
|Total current liabilities||$17,000.00||$32,000.00|
|Other long-term liabilities||$35,000.00||$90,000.00|
|Total Liabilities & Shareholders’ Equity||$282,000.00||$399,000.00|
How to create a balance sheet for your business
Step 1. Include the reporting date.
Before starting to write anything down, determine the date the balance sheet will use. Most of the time, this is the last day of the accounting period (such as a month, quarter, or year).
Step 2. Identify assets.
Tally up the assets for the time period specified in the step above. Split the assets into two categories: current and non-current, then split them off into individual accounts from there. All of these will get listed in the assets section of the balance sheet. These accounts are totaled under the current and non-current categories and then totaled again under Total Assets.
Step 3. Identify liabilities.
Similar to Step 2, this time, identify all the liabilities for that same time period. These will also fall under two categories of current and non-current, then further divide the liabilities into their individual accounts.
Step 4. List shareholders’ equity.
For companies with a single owner, this section is pretty easy. However, publicly held companies will have more calculations to perform to get the correct amount. In those situations, the following is included:
- Common stock
- Retained earnings
- Treasury stock
- Preferred stock
Step 5. Calculate your total.
The last step totals the assets, liabilities, and shareholder’s equity to ensure it balances. Assets should always equal the total liabilities and shareholders’ equity. When the balance sheet doesn’t balance, it’s important to review all steps above and find missing or erroneous information.
Frequently asked questions about balance sheets
As the name suggests, the balance sheet always has to balance in the end. The assets always equal the total liabilities and shareholders’ equity. When you find the balance sheet numbers are off, there could be a couple of different reasons:
• Incomplete data
• Transactions entered erroneously
• Errors in exchange rates
• Inventory errors
• Incorrect equity calculations
• Miscalculated depreciation
The balance sheet has three sections: assets, liabilities, and shareholders’ equity. The assets must equal the amount of liabilities and shareholders’ equity.
A balance sheet is a risk assessment. Companies searching for potential investors need to ensure their balance sheet shows a company worthy of investment. Though the balance sheet has limitations, it provides a snapshot in time of all assets and liabilities the company currently has. Potential investors use this information to determine whether they want to take on the risk of providing more funds, especially if the company makes risky decisions.
The balance sheet is easy to put together and can even be done by the company’s owner, especially in small businesses—though larger businesses will need an outside auditor. A couple of steps will help form a balanced balance sheet as long as the company keeps well-maintained records. The most important thing to remember is to balance assets with liabilities and shareholders’ equity.
Agata Kaczmarek has held a passion for writing since early childhood. A professional writer for many years, Agata specializes in writing articles and blogs focused on finance as someone who holds a Master’s Degree in Accounting and Finance.
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