What is a balance sheet and how should my business use one?
If you’ve ever heard an accountant talking about “balancing the books,” of those books he’s referring to, the balance sheet is the one that really matters. A business balance sheet lists all assets, liabilities and equity over a given period to provide not only the overall financial position of the company but also its current net worth.
It is the most important of the three financial statements that make up a typical financial report (alongside a cash flow report and income statement) and is analysed to provide insight into a company’s overall financial position.
While there is no specific balance sheet definition, it could be considered in layman’s terms as the stick against which every other aspect of the business is measured. It’s important enough that you’ll also certainly want an accountant to help you with your first balance sheet, regardless of the size of your company. Even so, it’s important to understand balance sheet accounts and how they work.
How does a balance sheet work?
A balance sheet visualises the total amount of assets, liabilities and equity in a company. Of course, the specific terms will vary depending on the industry but generally speaking, it’s these three items that are featured on a typical balance sheet.
An asset, whether liquid or non-liquid, is anything that can be considered a positive financial item. Assets such as equipment and buildings are listed as non-liquid or fixed assets, and cash or assets that could quickly be converted into cash (inventory, accounts receivable etc.) are listed as liquid or current assets. There are also intangible assets such as copyright and patents to consider.
Any debts or funds owned by the company are considered liabilities. This includes accounts payable, wages, rental or mortgage payments and even employee pension plan contributions – any finances that are leaving the business. These are all considered short-term liabilities, whereas debts such as interest and deferred tax liabilities are considered long-term.
You get your equity by subtracting your liabilities from your assets. What’s left is split into dividends, which are used to pay shareholders, and retained earnings that are put back into the company either for growth opportunities or to pay off debts.
What does a balance sheet show?
A balance sheet is a snapshot of a moment in a company’s financial life that reveals what it owns, what it owes and how much shareholders have invested. Taken alone, it’s going to prove of little value to you besides being necessary for the taxman. When compared to balance sheets from previous periods, however, or to balance sheets from other businesses in the same industry, it can be an invaluable resource.
The balance sheet can be used to generate several financial ratios that help provide context and let a business owner and other stakeholders understand trends. This will have a direct impact on the next steps taken and the financial choices made.
Of course, there are drawbacks. The balance sheet can, for example, be made to look more favourable using certain rogue tactics. The fact that it’s a static statement does also mean that it requires other statements to make it worthwhile. Thankfully, most accountants will also keep cash flow and income statements that can be used alongside the balance sheet to give a fuller picture of a company’s financial situation.