Understanding your balance sheet
Many business owners find the balance sheet the hardest financial document to understand and interpret. This guide offers a simple explanation of the balance sheet, relates it to the profit and loss statement, and explains how you can use it to better manage your business.
The two major financial statements produced by most businesses are their balance sheet and profit and loss statement. For many businesses these are produced once a year by their accountant and promptly forgotten about – often because non-accountants can find them hard to understand.
However, it’s well worth taking the time to understand them because they can give you invaluable information about your business and help you manage it better. They’re also used by potential lenders and/or investors to help them decide whether to support your business – so it pays to be familiar with them.
This guide provides a simple overview of your balance sheet, what it tells you and how it relates to your profit and loss statement. You should also read our guide ‘Understanding your Profit and Loss statement’.
Your balance sheet is a snapshot of the health of your business
In simplest terms, a balance sheet is made up of three components:
- What the business owns — its assets.
- What the business owes — its liabilities.
- The overall value of the business (its assets minus its liabilities) – this is known as the owner’s equity (it’s also sometimes referred to as the ‘book value’ of a business).
The purpose of the Balance Sheet, as its name suggests, is to balance these. That’s why the bottom line figures on a Balance Sheet must always match each other. This is known as ‘the accounting equation’: Assets = Liabilities + Owner’s Equity. The simple example below illustrates this:
Assets
Current Assets
Cash: $15,000
Accounts receivable: $20,000
Inventory: $30,000
Total Current Assets: $65,000
Fixed Assets
Equipment: $100,000
Total Fixed Assets: $100,000
Total assets: $165,000
Liabilities
Current Liabilities
Accounts payable: $9,000
Bank overdraft: $11,000
Total current liabilities: $20,000
Long term liabilities
Loan payable: $25,000
Total long term liabilities: $25,000
Owner's equity: $120,000
Liabilities + owner's equity: $165,000
Some definitions
Some of the terms used in a balance sheet can be confusing. Here’s an explanation of the main terms you’ll see (some accountants or accounting packages may use slightly different terms):
Assets
Assets can be ‘current’ or ‘fixed’.
Current assets are things you own that last less than 12 months and that you can convert into cash fairly quickly. For example, current assets in the balance sheet above include the cash in, inventory or stock (the things you have for sale), and the money owed by customers (accounts receivable). Money in your business bank account is another current asset.
Fixed assets (sometimes known as ‘non-current’ assets) are things you own that will last longer than 12 months. In the balance sheet above the fixed assets are $100,000 worth of equipment. Other fixed assets can include buildings, vehicles, and machinery.
Some assets can’t be counted
Some things you’ve created can’t be easily counted, such as your brand, your reputation, and any trademarks. While important, they aren’t included on your balance sheet.
Liabilities
Liabilities can be ‘current’ or ‘long-term’.
Current liabilities are amounts you owe that you will have to repay within 12 months. The current liabilities for the business in the example balance sheet are outstanding invoices (accounts payable). Taxes are another example of a current liability.
Long-term liabilities are amounts you owe that you pay over a longer period. In the example above there is a long-term liability in the form of a $25,000 loan. Other examples include business mortgage payments and lease payments for equipment or vehicles.
Using your balance sheet
You can compare your latest balance sheet with earlier ones to check whether your business is getting stronger or weaker.
In particular, you can use the information in your balance sheet to easily create key ratios that you can compare against industry benchmarks or past performance to identify and fix potential issues in your business. For example, they can help you answer questions like:
- Are you making enough margin?
- Is your stock turning over fast enough?
- How efficient is your business?
- Do you have enough cash to pay your bills when they come due?
For more on how to use the information in your balance sheet to manage your business better, see our guide ‘Checking the health of your business’.
So, next time you receive or produce a Balance Sheet, don’t put it in a drawer and forget about it. Taking the time to understand and review it can help you build a better, stronger business – and a bigger bottom line.
How your balance sheet and your profit and loss statement work together
Your profit and loss statement, as the name suggests, measures your profitability over a certain period (e.g. a month or a year). It enables you to identify trends that can impact your profit.
Your balance sheet is a snapshot of your business and its overall health at a particular point in time. It contains information you can use to measure many different aspects of your business (more on this below). Balance sheets were typically produced once a year by your accountant, but accounting packages now allow you to produce a balance sheet any time you like.
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