Balance Sheet Explained – A Basic Guide

Balance Sheet Explained

A balance sheet is one of the three most important financial statements. It provides a crucial insight into how your business is doing financially at a given point in time. This article will take a deep dive into the ins and outs of balance sheets.

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Balance sheet explained 

Simply put, a balance sheet displays a business’s assets, liabilities, and owner’s equity at any given point in time. A balance sheet provides an overview of what your business owns, what it owes, and the amount invested by its owners. In other words, it summarizes your business’s worth, so you can better understand its financial position. A balance sheet is also known as a statement of financial position. 

Key components of a balance sheet 

A balance sheet has three main parts: assets, liabilities, and shareholder’s equity. In each part, relevant items are listed and they must match the accounts outlined on your chart of accounts. 

Let’s take a closer look at the three components of a balance sheet:

  1. Assets 

The assets section lists everything your business owns that provides economic benefits. The sub-items are arranged in order of liquidity, or how easily they can be converted to cash. 

The assets section is divided into the two following categories: 

Current Assets: Assets that can be turned into cash within one year. Here are some current assets that companies commonly own:

  • Money in a checking and/or savings account
  • Cash equivalents (currency, stocks, and bonds)
  • Accounts receivable (money customers owe when buying products/services on credit)
  • Short-term investments
  • Prepaid expenses
  • Inventory

Non-Current Assets (Long-Term Assets): assets that will take more than one year to be converted to cash. Some examples of non-current assets are:

  • Land and property 
  • Machinery and equipment 
  • Intellectual assets (copyrights, patents, trademarks, etc.)
  • Goodwill (value from brand name, customer base, reputation, etc.)
  • Long-term investments 
  1. Liabilities 

Following the assets section are liabilities. Your liabilities are everything that you owe to others. Similar to assets, liabilities are also broken down into current and long-term liabilities.

Current liabilities are debts due within a year. Items are listed in order of their due date. Here are some examples:

  • Rent 
  • Utilities
  • Taxes
  • Short-term loans
  • Accounts payable (money owed when buying goods on credit) 
  • Interest payments

Long-term liabilities have due dates longer than one year. For example:

  • Long-term loans
  • Deferred income taxes
  • Pension fund liabilities.
  1. Equity 

Equity is the last section in a balance sheet. It refers to the money owned by the business owners or shareholders. In other words, equity is your net assets. The most common items belonging to this section are:

  • Capital (money put into the business by the owners)
  • Private or public stock
  • Retained earnings (net earnings to reinvest or pay off debts)

The balance sheet golden rule 

A balance sheet must follow a golden rule or an accounting formula as follows:

Assets = Liabilities + Equity

What your business owns always has to be balanced with what it owes plus its equity. This is because your assets either come from your borrowings or your own money. 

What does a balance sheet look like?

Normally, a balance sheet will be divided into two columns: assets on one side and liabilities plus equity on the other. However, it’s not unusual to see a balance sheet looking like a long, endless list. You decide the format most suitable to your business! 

Source: FundNet 
Source: Accounting Guide 

Why is a balance sheet important? 

A balance sheet is an important financial document as it allows you to look at your business’s position in detail. When comparing the current balance sheet to ones in the past, you can analyze and understand your business operations better. Think of it as a regular health check for your company. The balance sheet allows you to make better decisions by giving you an insight into what your business is doing well and what it’s not.

Here are a few financial areas that can be improved by leveraging a balance sheet:

Liquidity 

It’s always challenging for any business to calculate how much cash they have readily available. With the figures on a balance sheet, businesses can work out and analyze critical financial metrics like the current ratio (current assets ÷ current liabilities) or quick ratio ((current assets – inventory) ÷ current liabilities). Interpreting these ratios correctly will help you find the best ways to manage your company’s liquidity.    

Efficiency 

You can determine how efficiently your company uses its assets by comparing your balance sheet with other financial statements. Through calculations and analysis, you’ll be able to determine which areas in the business are generating profits. Then, you can make better plans for future investments or capital allocation.  

Risks

Your balance sheet summarizes how much debt you owe, which can tell you how much financial risk you face. Being aware of your debt situation allows you to make wiser business decisions and avoid potentially damaging events that could lead to bankruptcy. 

Who prepares the balance sheet?

Depending on your business’ size and model, the balance sheet may be prepared by different people. For example, in a small privately-owned business, a bookkeeper will prepare the balance sheet. For a mid-size private firm, their accountants may prepare it first, then have it reviewed by an external accountant. 

Key takeaways 

The balance sheet is an important financial document that you can’t overlook. Understanding what it is, how it works, and how it correlates to the rest of your business are a great advantage for any business owner. 

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