What is a Balance Sheet?
Balance sheets are one of the primary financial statements used to measure a company’s financial position. It summarizes the company’s assets, liabilities, and owners’ equity at a specific date, and it is used to calculate the net worth of the business. Creating and keeping your balance sheet up to date will allow you to have a better handle on your company’s finances.
Understanding your company’s balance sheet is vital to ensuring it has a strong financial position.
Typically, when assets are greater than liabilities, this represents a strong financial position. But when liabilities are greater than assets, this can represent a weak financial position and a company with lower value.
Having an accurate balance sheet can help you assess the company’s strengths and weaknesses and develop appropriate strategies moving forward. Balance sheets can help you identify trends and are commonly used for bank loans and selling your small business.
There are two other financial statements that are connected to the balance sheet:
- An income statement reports revenue, expenses, and net income for a specific period. The net income balance in the income statement increases an owner’s equity in the balance sheet.
- A cash flow statement lists the cash inflows and outflows for a month or year, and the ending cash balance is the same dollar amount reported in the balance sheet. If you create a July cash flow statement, for example, the July 31st cash balance in the cash flow statement equals the cash balance in the July 31st balance sheet.
Assets include all items of cash and property held by your company. Usually, assets on the balance sheet are divided into two categories: current assets and non-current assets.
Examples of assets include:
- Cash, such as money in petty cash, deposits in checking and savings accounts, and any short-term investments that can readily be converted into cash.
- Marketable securities, including stocks, bonds, and other securities held for investment that are readily tradable.
- Accounts receivable (A/R) owed to your company by a customer or client that is expected to be paid within a year.
- Inventory, including raw materials, works in progress, and finished goods produced or acquired for sale to customers in the normal course of business. Businesses may have an obsolescence reserve that reduces the inventory asset on the balance sheet.
- Pre-paid expenses, such as amounts for insurance coverage, property taxes or other expenses that you expect to use or apply within one year.
Non-current assets include:
- Property, such as equipment and machinery, buildings and land, and furniture and fixtures. Accumulated Depreciation
- Intangible property, including copyrights, patents, and trademarks, as well as goodwill.
- Other Non-current assets
Liabilities are debts or other obligations of the company that could have a negative effect on its net worth. There are two basic categories of liabilities: current liabilities and long-term (fixed) liabilities.
Current liabilities, which are liabilities reasonably expected to come due within a year, include:
- Accounts payable (AP) owed to suppliers and vendors for goods or services bought by the company.
- Notes Payable
- Accrued expenses incurred by your business without any invoice, such as wages, employee benefits (e.g., medical insurance, retirement plan contributions), and profession fees
- Short-term borrowing, which includes company credit card bills and lines of credit.
- Payroll Payable
- Sales Tax Payable
- Income Tax Payable
- Short-term loans payable
- Unearned revenue from a product or service that has yet to be delivered or performed.
Long-term (fixed) liabilities include:
- Mortgages taken out to buy or build the company’s facilities (e.g., buildings, factories, etc.)
- Bank loan for company vehicles
- Bank loan for equipment purchases
- Loans from the shareholders
This portion of the balance sheet represents the value of your owner’s interest in the company. Subtracting the liabilities from the assets gives you the value of your equity.
Owners’ equity breaks down into four basic categories:
- Common shares
- Profit or Loss for the current year
- Dividends distributed to the owners
- Retained revenue, or the earnings of the business that are kept in the company rather than being distributed to the individual owners
If you have positive equity, your assets exceed your liabilities. If your equity is negative, there are more liabilities than assets, and the company could be in trouble.
Balance Sheet Formula
Those three components are connected by the balance sheet formula:
Assets = Liabilities + Owners’ Equity
Owners’ Equity = Assets – Liabilities
The formula is used to create the financial statements, including the balance sheet and will give you an accurate snapshot of your company’s financial health.
How to Create a Balance Sheet
To create a balance sheet manually, use two columns for entries of the items discussed earlier. The left column is for listing your assets, with a total of assets at the end of the column. The right column is for listing liabilities, which you total and add to the owners’ equity. When the sum of liabilities and owners’ equity is totaled, the amount should be equal to the total amount of assets in the left column.
For example, say you run a small business. Your current assets might include $2,000 cash in the bank plus $500 in accounts receivable for an unpaid invoice and $3,000 worth of inventory (raw materials, packaging material and finished product). Your fixed assets might include furniture and fixation worth $500, and $7,000 in equipment, and $1,000 for your computers and point-of-sale equipment. The numbers on the asset side of your balance sheet look like this:
($2,000 + 500 + 3,000) + ($500 + 7,000 + 1,000) = $14,000
The right side of your balance sheet shows your liabilities. Your current liabilities might include $1,000 in accounts payable for raw material, packaging material and finished goods, $500 for sales tax, and $1,500 owed in salary and wages to your employees. Your long-term liabilities might include $4,000 outstanding for a business loan you took to start the company. The numbers on the liabilities side of your balance sheet look like this:
($1,000 + 500 + 1,500) + 4,000 = $7,000
When you subtract your liabilities from your assets ($14,000 – 7,000), the remainder ($7,000) is your owners’ equity.