Understanding Balance Sheets

Let’s take a look at the balance sheet, which presents a snapshot of a company’s financial position at a specific moment in time, often on the last day of the month, the quarter or the year.

The left side of the balance sheet lists a company’s assets (i.e. the things that it owns). The right side lists the liabilities and equity, which represent the financial obligations that the company has to others. Assets are listed in order of liquidity, or the length of time that it takes to convert them into cash, and liabilities are listed in the order in which they must be paid.

Now let’s take a look at this sample balance sheet from the fictitious ABC Corporation and break down each of the items in a little more detail.

Assets on the Balance Sheet

• Cash – This one is pretty easy. In addition to actual bank notes, cash also includes any money that is immediately available, such as funds in a checking account. Cash is, by definition, the most liquid of all assets.
• Accounts receivable – This represents money that is owed to ABC Corp. by its customers.
• Inventory – Inventory is the value of the goods that ABC has in its possession but has not yet sold.
• Total current assets – Are all assets that can be easily converted into cash within a year. In ABC’s case its total current assets are the sum of its cash, accounts receivable, and inventory.
• Fixed Assets – Fixed assets include things such as buildings, machinery, and office equipment which are necessary to run the business but which are not expected to be converted into cash.
• Total Assets – Equals the sum of all of the assets of ABC Corp., in this case the figure adds up to $50,000 and is comprised of $35,000 in current, or short-term, assets and $15,000 in fixed, or long-term assets.

Liabilities and Equity on the Balance Sheet

• Accounts payable – The opposite of accounts receivable, this figure represents the money that ABC owes to suppliers, vendors, and other creditors that is due within a year.
• Notes payable – Are loans that must be repaid within a year.
• Accrued payroll – Is money that is owed to employees. Because ABC, like most companies, does not pay its employees daily it will accrue this liability to its employees between paydays.
• Total current liabilities – All liabilities that must be paid within a year. In ABC’s case, this includes accounts payable, notes payable, and accrued payroll.
• Long-term debt – Is any financial obligation of ABC’s that is due more than one year from the date the balance sheet was prepared.
• Total liabilities – Equals total current liabilities plus long-term debt.
• Common stock – Represents the value of the stock that has been issued to investors in ABC Corp.
• Retained earnings – Are the earnings of ABC that have been reinvested into the business.
• Total common equity – Also known as owners’ equity or stockholders’ equity, this figure is the sum of the value of the common stock plus retained earnings.
• Total liabilities and equity – Comprises all of the money that ABC owes to others, plus the value of its common stock and retained earnings, in this case $50,000.

While the precise line items on a balance sheet will differ from company to company, the format that we have laid out here will not vary. And while each company will, of course, have its own unique values for each entry on the balance sheet, one thing that holds true for ABC Corp. holds true for all companies: total assets are equal to total liabilities plus equity. 

If ABC Corp. were to sell off all of its assets it would receive $50,000; if ABC pays off all of its liabilities it will have to shell out $38,000 leaving it with $12,000, which is equal to the company’s total common equity. Thus, we see that assets minus liabilities equal common equity, and some simple math then tells us that total assets are equal to total liabilities plus equity.

Common equity is what is left when liabilities are subtracted from assets and is therefore sometimes referred to as the net worth of a company.

What exactly can a balance sheet tell a small business owner? 

A balance sheet can help you to gauge the financial health of your company's current assets and to analyze trends that may be occurring over time. 

It is also one of the cornerstones of financial reporting that lenders and investors will want to analyze before deciding whether or not to provide funding to your business.

One very important figure we can calculate is the current ratio, which is equal to current assets divided by current liabilities; in our example $35,000/$18,000 equals a current ratio of 1.94. Because the current ratio measures a company’s ability to pay its short-term liabilities, it is a favorite of banks and other lenders.

While current ratios will vary from industry to industry, a general rule for small businesses is that lenders like to see a current ratio of at least 2.0.

Because inventory typically represents the least liquid of a firm’s current assts, we also want to gauge short-term financial health without relying on converting inventory into cash. We accomplish this by looking at the quick ratio, which is equal to current assets minus inventories, divided by current liabilities.

A company’s quick ratio (in our case ($35,000-$10,000)/$18,000 = 1.39) will obviously be lower than its current ratio but it will hopefully be greater than 1.0, meaning that it can pay off its current liabilities without having to worry about selling its inventory.

Because it represents a picture of a company’s financial situation at a specific moment in time, a single balance sheet is not useful for analyzing trends. In order to do this, though, we simply have to look at two or more balance sheets and see how things have changed over time.

For example, are your inventories growing much faster than your revenues? If so, this may be a sign that you are stockpiling too much product at the expense of more liquid assets like cash.

You’ll also want to keep a close eye on how your receivables change over time. If they are increasing faster than your revenues, then you may need to improve your collections process and take a realistic look at who owes you money and how likely they are to pay it back. If you find that you have one or two problem customers, it may be time to have a talk with them.

Hopefully, you now have an idea of what your company’s balance sheet is all about and how to read if for clues as to the health of your finances. While our discussion has been by no means comprehensive, it should have left you with an understanding of some of the most important information that a balance sheet contains.

For even more detailed analysis, a college or MBA level financial management textbook can be a great resource.