January 17, 2022
Candace J. Dixon
The balance sheet is the most important of the three main financial statements: Balance sheets show what a business owns and what it owes at a fixed point in time; income statements show how much money a business made and spent over a period of time; and cash flow statements show how much cash entered and left a business in a given period of time. Understanding what goes into a balance sheet and what it tells you about your business is essential to business owners.
What is a balance sheet?
A balance sheet, also known as a statement of financial position, is a statement of a business’s assets, liabilities, and owner’s equity as of a given date that shows a business's net worth. A balance sheet is typically prepared at the end of set periods, such as monthly, quarterly, or annually, although it can be done at any time. It is used with the income statement and cash flow statement to determine the financial health of a business.
How do you prepare a balance sheet?
A balance sheet has two columns. The left column lists the assets of the business, and the right column lists the liabilities and the owners’ equity. The total of the liabilities and owners’ equity equals the assets, which is the basic accounting equation, asssets = liabilities + owner's equity. Assets have to equal, or "balance," the total of liabilities and shareholders' equity.
A simple example:
When a business is started by an owner who contributes $1,000 cash, it has assets of $1,000, no liabilities, and owner’s equity (their contribution to the business) of $1,000.
Assets
Assets are things a business owns that have value; they can either be sold or used by the business to make products, or to provide services that can be sold. Current assets are combined with non-current assets to show total assets on the balance sheet. They are listed in order of how easily they can be convered into cash.
Current assets are those expected to be sold, consumed, or used within one year, and they can be converted easily into cash. Current assets are used to measure the liquidity of a business.
Current assets include:
Cash and cash equivalents
Accounts receivable
Supplies
Prepaid expenses
Inventory
Short-term investments
Non-current assets have a lifespan of more than a year and are more difficut to convert to cash.
Non-current assets include:
Computers
Machinery
Buildings
Land
Long-term investments
Intangible assets (goodwill, trademarks, copyrights and patents)
Liabilities
Liabilities are amounts a business owes others for debt or expenses as well as obligations to provide goods or services in the future. They can be both current and long-term and are listed in order of how soon payment is due.
Current liabilities are liabilities that have to be paid within a year.
Current liabilities include:
Accounts payable
Wages payable
Sales tax payable
Utilities
Rent
Short-term debt such as bank loans
Dividends payable
Income taxes owed
Non-current liabilities include:
Long-term loans
Mortgage
Owner’s equity
Owner’s equity (or shareholders' equity) is what would be left for the owners from the business assets after paying off all of its liabilities. It’s what owners have invested in the business.
In sole proprietorships, owner's equity is the owner’s investment of cash and property into the business less withdrawals, such as monthly draws for the owner's personal living expenses.
In corporations, owner’s equity is called shareholder's equity (capital or net worth). It represents the value of corporate stock and retained earnings. When earnings are distributed to shareholders instead of retained, the distributions are called dividends. Retained earnings are earnings not paid, or dividends "retained" by the corporation.
Comparing owner’s equity from one period to the next shows how an investment in the business is doing. If owner’s equity declines, changes may need to be made such as paying off debts and reducing liabilities. If owner’s equity is increasing, that’s a positive thing. Accounting software prepares balance sheets based on the information that has been input, so the report is only as accurate as the information provided and entered. There are also templates that businesses can use to create balance sheets.
What does a balance sheet tell you?
The balance sheet gives insight into how a business is doing financially. There are different ratios used to do this. Here are just a few:
Debt ratio
Debt ratio is one of the most important ratios. It is found by dividing total liabilities by total assets to get a percentage (total liabilities ÷ total assets).
For example, if a business has assets of $100,000 and liabilities of $55,000, the debt ratio is 55% ($55,000 ÷ $100,000).
While its good if assets can cover debts, it’s not wise to have too much debt compared to assets. The larger the debt ratio percentage, the more the company is leveraged. There could be problems when a business is too heavily leveraged. The acceptable debt ratio varies by industry.
Current ratio
Current ratio is a liquidity ratio used to measure a business's ability to pay short-term and long-term liabilities. You divide current assets by current liabilities to find the current ratio (current assets ÷ current liabilities)
Quick ratio
Quick ratio is the same formula as the current ratio, current assets divided by current liabilities, except you don't include inventory. The quick ratio measure of liquidity only includes current assets that can be converted quickly to cash to pay off current liabilities.
Who uses the balance sheet?
The balance sheet is used by business owners to monitor their business's financial health. They may use it to figure out how to meet obligations or to determine the best use of credit. They also use it when looking for financing; checking on how their investment is doing; or selling the business and determining its net worth.
Lenders look at the balance sheet: Banks want to know if a business is getting paid for its accounts receivable on time before giving them credit. Also, when a business applies for an SBA 7(a) business loan over $350,000, a balance sheet is required.
Investors and buyers look at the balance sheet to assess a business's financial viability and determine its profitability.
The balance sheet and income taxes
Only C corporations are required to complete a balance sheet as part of their federal tax return because the IRS wants to see that the balance sheet included with Form 1120 - U.S. Corporation Income Tax Return agrees with the corporation’s books. It compares items at the beginning of the year to items at the end of the year. Small corporations having total receipts and total assets less than $250,000 at the end of the year are not required to complete a balance sheet with their tax returns.