Understanding Owners Equity: Definition, Calculation, and Importance
Owner’s equity describes an investment in a company in exchange for ownership rights. Owner’s equity reports similar items as shareholder’s equity. The …
A balance sheet is an accounting report that outlines a company’s assets, liabilities, and equity for a point in time. Balance sheets are one of the main financial statements a company will issue, alongside the income statement and cash flow statement. Balance sheets give important insights into a company’s financial health, helping investors, lenders, and other third parties make informed investment decisions.
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.
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 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:
Here is a list of non-current assets:
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:
Here is a list of non-current liabilities:
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 Owner transactions include money contributed and withdrawn from the company.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.
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 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.
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.
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.
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.
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.
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.
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