Balance sheet basics: Your guide to understanding financial statements
What is a balance sheet?
A balance sheet is a financial statement that lists a company’s assets, liabilities and owner's equity to provide an overview of the business’ financials at a specific point in time. Businesses typically prepare and distribute their balance sheet at the end of a reporting period, such as monthly, quarterly or annually.
Why do you need a balance sheet?
Balance sheets help you understand the financial health of your business. All assets and liabilities are visible in the same financial statement for an at-a-glance view. Balance sheets provide a valuable resource for owners, investors and creditors to see whether the company has enough assets to cover its obligations over the short and long term.
Comparing balance sheets from different reporting periods allows for analysis of a company’s financial performance over time. By examining changes in assets, liabilities and equity, stakeholders can assess how a company has grown, identify trends and spot potential issues. This financial information provides potential investors with the key information they need to decide whether to fund a company.
You can use a balance sheet to understand your company’s current financial position, make informed decisions, and pinpoint ways you can improve your company’s financial health.
Balance sheet components
On your balance sheet you should list assets in order of liquidity, based on how quickly you can turn them into cash. The assets column of a balance sheet should include current assets and long-term assets:
Cash (and cash equivalents)
Cash includes cash in the bank, stock held and money owed to the business.
Accounts receivable (AR)
Accounts receivable should list any cash currently owed to the company.
This includes any publicly-traded assets that can be quickly converted to cash — usually stocks, shares and bonds.
Inventory refers to the value of any unsold stock, as well as raw materials and work-in-progress (if applicable). Its value on the balance sheet is the lesser of its cost or net realisable value, which is its selling price minus costs.
This category includes assets with a lot of capital investment, such as land, buildings, vehicles and equipment.
This includes non-physical assets, like computer software licences, trademarks, patents and intellectual property. You should only need to list these on your balance sheet if you’ve acquired them (that is, you didn’t create them in-house).
This refers to investments in securities that you don’t anticipate liquidating in the next year. Long-term securities can take various forms, including equity investments, government and corporate bonds, and more.
Opposite to assets, liabilities refer to any money you owe external parties. This includes accrued wages, accounts payable, commercial rent, credit cards payable, loan repayments and more.
This category includes current or short-term liabilities, which are due in the next year, and long-term liabilities, which you’d expect the business to repay over a longer period than a year.
Current liabilities may include:
This refers to dividends declared by a company’s board of directors but that haven’t yet been paid to shareholders.
Income taxes payable
This is any tax owed to the tax office that is not yet paid.
Currently-due portion of long-term debts
This accounts for the total amount of debt repayment due in the next year. For example, if you’ve taken out a 10-year loan, one year’s worth of payments is the currently-due portion of debt. The remaining 9 years of payments are a long-term liability because they aren’t due in the next 12 months.
Long-term liabilities may include:
This refers to any repayments for loans or borrowings with a repayment period of more than a year. This includes mortgages, long-term bank loans and other forms of long-term finance.
Deferred tax liability
This figure is the amount of taxes that have accrued but aren’t due within the current financial year.
This includes leasing agreements for assets such as real estate, equipment or vehicles, which may run for many years.
Owner’s equity (or stakeholder equity) represents the amount of money that a company would return to its owner after deducting all liabilities from the total assets.
How to set up a balance sheet
1. Choose the reporting date
Firstly, choose the specific date to prepare your balance sheet. It could be the end of the financial year or any other reporting period.
Many companies choose to report quarterly as this provides regular financial insights without the need to create a balance sheet every month. A balance sheet is used to present a company’s financial position on a specific day.
2. List your assets at reporting time
Categorise your assets into current (expected to be converted into cash within a year) and long-term. Add each asset as a line item within the relevant category and assign appropriate values. Assets are typically valued at their cost or net realisable value, whichever is lower. Calculate the subtotal of current assets and long-term assets, and add them together for your total assets.
3. List your liabilities at reporting time
Similarly to your assets, classify your liabilities as current (due within a year) or long-term. Add each liability as a line item in your balance sheet and assign the current outstanding amount to each. Calculate the subtotal of both categories, and add them together for your total liabilities.
4. Determine owners' equity
Now you have a total for your assets and liabilities, you can work out the owner’s equity. The total assets should be equal to the total liabilities and shareholder’s equity. So, if you subtract the company’s liabilities from your total assets, you can work out the owner’s equity. As long as your assets are higher than your liabilities, your equity share will be in the positive.
5. Review and verify
Thoroughly review the balance sheet for accuracy and completeness. Double check calculations and ensure all relevant information has been included. Use your balance sheet to understand your company’s current financial position and make any necessary changes to ensure long-term viability.
Balance sheet example
You can use a template to set up a balance sheet for your business. Alternatively, you can enlist the help of an accountant or bookkeeper or use accounting software to generate a balance sheet report for you.
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