Balance sheet

A balance sheet (aka a statement of financial position) is a document showing the net worth of your company at a particular moment of time. It usually looks like a table with sections stating how much money your company owns/owes and how much is invested and owned by the shareholders.

It goes hand in hand with 2 other key financial statements that are used to evaluate a business  — an income statement and a statement of cash flow between the two, known as the cash flow statement. All these financial statements might be prepared by bookkeeping services.

What is the structure and purpose of the balance sheet?

A balance sheet is divided into 2 sections: the first one is Assets, the second one is Liabilities + Equity. Assets must be in balance with (equal to) liabilities + equity, which explains the balance sheet name.

The purpose of the balance sheet is to help you evaluate your business, both its internal health and in comparison to the companies operating in the same business niche.

Assets

Assets on the balance sheet are what your company owns  — such is cash, inventory, property, etc. Assets are listed in order of their liquidity, or how easy they can be converted into cash — with cash itself topping the list.  

The liquidity defines whether the assets are considered to be current and non-current. Current are those which can be converted to cash within a year (or less). Non-current (or long-term, or fixed)  are those taking more than a year to be converted.

Current assets

  • Cash and cash equivalents (such as stocks and bonds)
  • Accounts receivable (money your customers still owe to you)
  • Short term-investments
  • Inventory (your company’s goods, valued at the lowest cost or market price)
  • Prepaid expenses (such as advertising contracts, insurance or rent)

Non-current assets

  • Tangible fixed assets (such as buildings, land, machinery, equipment, etc).
  • Intangible fixed assets (such as patents, trademarks, etc.)
  • Long-term investments

Liabilities

Liabilities are what your company owes — such as loans, taxes, salaries, etc. Their place in order is also defined by a factor —  in this case, it is their due date. If they are due to be paid within a year, they are current; if more than a year — they are long-term.

Current liabilities

  • Accounts payable (that is what you owe suppliers for what you have bought on credit)
  • Salary (the money you owe your employees for working hours that are already completed)
  • Loans that you must pay within a year
  • Taxes you owe

Long-term liabilities  

  • Long-term debt (interest on bonds issued)
  • Loans that you don’t have to pay within a year
  • Pension fund contributions (the money your company must pay to your employees’ retirement accounts)
  • Deferred tax liability (taxes you are expected to pay, but haven’t done it yet)

Equity

It is also called net assets, net worth, or just capital — it is the money currently held by your company. The Equity part shows what belongs to the business owners: in case of sole proprietorships, it is called “owner’s equity“, for limited companies — “shareholders’ equity”.

Equity includes:

  • Capital (the money invested by the owners)
  • Private or public stock
  • Retained earnings

The formula used for a balance sheet & Balance sheet example

A (assets) = L (liabilities) + E (equity). Let’s examine a balance sheet example. Say, a company has:

Assets:

Cash — $2,050

Accounts receivable — $6,100

Inventory — $900

Total assets — $9,050

Liabilities

Accounts payable —  $150

Wages payable — $2,000

Total liabilities — $2,150

Equity

Common stock — $5,000

Retained earnings — $10,900

Drawing — −$9,000

Total equity — $6,900

Applying the formula, $9,050 (Assets) = $2,150 (Liabilities) + $6,900 (Equity).

When is the balance sheet made?

The balance sheet is prepared at the end of a reporting period, whether it is a month, a quarter, or a year. It is necessary to deliver it to shareholders and tax authorities. It is also used to show the financial status of your company, when you deal with creditors or investors.

How to make a balance sheet?

There are two ways to get your balance sheet ready: by using Excel and by using your online accounting software system. In case of an Excel file, you can do it either yourself, or download an Excel template from the Internet. With the accounting software, the balance sheet is completed automatically.

Does the balance sheet show the ultimate worth of your company?

The equity amount on the balance sheet is not the total worth of your business. The balance sheet doesn’t include the goodwill (or the worth of the customers built up by your business), or the value of your company’s know-how.

Balance sheet analysis & ratios

One balance sheet represents your company’s finances only for a particular moment in time, so to get a full picture of the company’s financial development, you should analyze it together with those from previous accounting periods.

However, only one balance sheet can also give you plenty of useful information, and special ratios exist for drawing conclusions from it. Ratios are used to compare different aspects of your company’s activities and also to compare its financial status with other companies in your industry or region.

Ratios can also help you find out if you have too much debt, or have spent too much on inventory or should get your receivables quicker. It is better to review the ratios at least on a monthly basis to keep yourself in the loop.

Ratios can be divided into 4 main categories:

  1. Leverage ratios. This includes debt-to-equity and debt-to-asset ratios which work as indicators showing your company’s ability to deal with the debts.
    Debt-to-equity. The formula of total liabilities/shareholders’ equity lets you know how much debt your company has, compared to the owners’ investments. For investors and bankers, it is an indicator of your company’s capacity to repay its debts.
    Debt-to-asset. The formula of total liabilities/total assets shows the percentage of your company’s assets financed by creditors. The higher the ratio, the weaker your business looks like, as it is more dependent on credit money.

  2. Liquidity ratios. This includes working capital ratio and cash ratio which show the amount of a company’s liquid assets (cash or assets that can be converted quickly) and how it corresponds with the company’s debts and other obligations.
    Working capital ratio (or current ratio). The formula of current assets/current liabilities shows whether a company has enough cash (including inventory and receivables as assets) flow to fulfill its short-term obligations.
    Cash ratio (or quick ratio, or acid test). The formula of liquid assets/current liabilities shows a company’s ability to pay out debt using only cash and cash equivalents like near-cash securities.

  3. Profitability ratios. This includes net profit margin, return on shareholders’ equity, coverage ratio and return on total assets. They show the financial viability of your company and help to compare your company to others in the industry.
    Net profit margin. The formula of after-tax net profit/net sales shows how much the company earns (after taxes, operation expenses and interest are paid) in comparison to how much it sold. The higher it is, the better.
    Return on equity of shareholders (ROE). The formula of net income/shareholders’ equity x 100% shows how much the company earns for each of the invested dollars. In other words, it defines the rate of the return the shareholders get on their investment.
    Coverage ratio (or operating profit margin). The formula of profit before interest & taxes/annual interest and bank charges shows a company’s capacity to generate income to pay the debt interest.
    Return on total assets (ROTA). The formula of income from operations (net profit before taxes) /average total assets shows how effectively a company uses its assets to generate earnings.

  4. Operations ratios. This includes accounts receivable turnover, average collection period, average days payable and inventory turnover which help to analyze your company’s operating expenses.
    Accounts receivable turnover. The formula of net sales/average accounts receivable shows how effective a company in collecting debts and extending credits. A higher turnover rate shows that customers pay quicker and less money is tied up in accounts.
    Average collection period. The formula is days in the period X Average accounts receivable/Total amount of net credit sales in period. It shows the amount of time between the sales were made and the money was collected from the customers. In other words, how quick the customers pay their bills.
    Average days payable. The formula is Days in the period X Average accounts payable / Total amount of purchases on credit. It shows the average number of days it takes your company to pay its bills and invoices to creditors, suppliers, vendors etc.
    Inventory turnover. The formula of cost of goods sold / Average inventory shows whether a company has an excessive inventory in comparison to its level of sales.

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