What is a balance sheet?

Although balance sheets are commonly used by business owners, they can apply to your personal situation as well. An individual might create a balance sheet to calculate their net worth, subtracting amounts owed from assets owned.

Components of a Balance Sheet

The balance sheet is made up of three main components: assets, liabilities, and equity. Let’s break down each of these components in more detail.

Assets

Assets are amounts your business owns and are broken down into two main categories: current and non-current. Current assets represent items that can easily be converted to cash within a 12-month period, while long-term assets are items that are more difficult to liquidate.

Here is a list of current assets in order of liquidity:

• Cash and Equivalents – These are the most liquid assets and include money in checking accounts, savings accounts, and short-term CDs.
• Marketable Securities – Debt and equity securities that are easily sold are considered very liquid assets.
• Accounts Receivable – Money owed from customers that is expected to be collected within the next 12 months is considered a short-term asset.
• Inventory – Inventory refers to any good available for sale and is usually categorized on the balance sheet at cost.
• Prepaid Expenses – This category of current assets holds items that your business has paid for upfront, such as a year-long software subscription.

Here is a list of non-current assets:

• Long-Term Investments – These are investments that can’t be liquidated in the next 12 months, such as a two-year CD.
• Fixed Assets – Land, equipment, machinery, furniture, buildings, and other fixed assets are found in non-current assets.
• Intangible Assets – These are assets that aren’t physical, such as goodwill, non-compete agreements, and patents.

Liabilities

Liabilities are the opposite of assets, representing amounts your business owes. Like assets, liabilities are broken down into current and non-current. Current liabilities are amounts expected to be paid within the next 12 months, while long-term liabilities are amounts that have a term longer than 12 months.

Here is a list of current liabilities:

• Accounts Payable – This account holds the money you owe to suppliers within the next 12 months.
• Wages Payable – Salaries and wages that employees earn but have not received are a current liability.
• Customer Deposits – When a customer prepays, you aren’t able to immediately recognize the income. Instead, the amount goes to the balance sheet as a current liability.
• Current Portion of Long-Term Debt – Debt payments that your business will make in the next 12 months are considered a current liability. The remaining portion will be found in long-term liabilities.

Here is a list of non-current liabilities:

• Long-Term Debt – Any loans or term liabilities that extend beyond a year will be found in non-current liabilities.
• Deferred Tax Liabilities – Certain businesses are required to track deferred taxes, which are non-current liabilities.

Equity

Equity tracks the retained earnings and owner transactions. Retained earnings is the income or loss that the business has generated since its inception. Owner transactions include money contributed and withdrawn from the company. Another category that might be found in equity is treasury stock. Treasury stock is the portion of ownership that the business has bought back from shareholders.

How a Balance Sheet Works

The balance sheet uses an accounting equation to determine any mistakes or issues in transactions. The balance sheet formula states that assets must equal liabilities plus equity. This generates the following equation:

Assets = Liabilities + Equity

Your company’s total assets must equal the sum of total liabilities and equity. If your balance sheet does not equal, there is a problem somewhere in your transactions.

The Importance of a Balance Sheet

The balance sheet is a core financial statement, making it important to regularly update and track. Here are some of the reasons why the balance sheet is important.

Determines Risk

The balance sheet equation gives you insights into the financial health and stability of your business. This allows you to take a proactive approach to planning and risk reduction. For example, if you calculate the current ratio (current assets divided by current liabilities) and find that you aren’t able to pay upcoming obligations, you can switch around your cash flow or secure other financing.

Understanding if you’ve borrowed too much money, overleveraged the business, or have excess cash on hand is important to make informed decisions surrounding risk, growth, and compliance.

Secure Capital and Investors

Most financial institutions and outside investors will not deploy capital to your business without tangible proof of your financial health. Providing your balance sheet allows external parties to assess the financial health of your organization, giving you the opportunity to secure capital, new investors, or term debt.

Reach Growth Goals

Members of management use the balance sheet to find ways to improve profitability, liquidity, and reach growth goals. By understanding what assets you have on hand and which liabilities are coming due, management can make decisions that align with your operational strategy and scalability goals.

Useful for Metrics

The balance sheet is integral when calculating ratios, such as the equity ratio, current ratio, and quick ratio. Metrics allow you to track progress between periods. For example, if you see that your net assets are increasing each month, it could indicate steady growth.

Other metrics, such as return on assets or days payables outstanding require data from your balance sheet. The more accuracy you have in your balance sheet, the more insightful and precise your metrics will be.

Balance Sheet Limitations

Despite the benefits, the balance sheet does have limitations. For one, the balance sheet only provides a small snippet of your company’s financial picture. To fully understand where your business stands, the income statement and cash flow statement need to be evaluated alongside the balance sheet.

In addition, the balance sheet is generated at a point in time, meaning balances are shown as of a specific date. Unlike the income statement that is a rolling total for a period, the balance sheet makes it difficult to extract performance over time. Pulling past balance sheets for comparison is one solution to understand how a company’s financial health has changed over time.

Furthermore, the balance sheet is subject to adjustments that can significantly sway results. For example, accounts receivable can contain invoices that will not be collected. If you were to evaluate the balance sheet on December 31, but then write off receivables as bad debt on January 1, there would be significant discrepancies in your evaluation of financial health.

Summary

• The balance sheet is an accounting report that outlines a company’s assets, liabilities, and equity.
• There are two classifications of assets and liabilities: current and non-current. Current means that the amount will be collected or paid within 12 months. Non-current items extend beyond a one-year period.
• The balance sheet equation states that assets must equal liabilities plus equity.
• Calculating the balance sheet is important to reduce risk, secure capital, reach growth goals, and implement metrics.
• The balance sheet does have limitations because it is calculated at a point in time and is subject to significant adjustments.