What are balance sheets and why are they important?

Do you gloss over the balance sheet in your business financial statements? Not sure what the numbers are telling you?

You are definitely not alone.

But that means you’re also missing out on seeing the big picture:

• the net worth of your business
• how much money you have
• where that money is kept

Understanding how to read a balance sheet is essential in managing cash flow in a small business.

In this article, we guide you through the basic terms plus how to read the statement as a whole, and how to read a balance sheet easily, so you can gain valuable insights into your business.

Here’s what we’ll cover

What is a balance sheet and why is it important?

It’s one of the 3 core financial statements to help you manage business cash flow.

The balance sheet provides an overview of the state of your business finances at a specific point in time, also known as the reporting date.

It’s generally used alongside the other 2 types of financial statements: the profit and loss account (also known as the profit and loss statement or income statement), and the cash flow statement.

Because the balance sheet reflects every transaction since your business started, it reveals your business’s overall financial health.

It tells you exactly what your business owns and is owed, as well as the amount you as an owner have invested.

But what it can’t do is give you a sense of the trends playing out over a longer period on its own.

For this reason, you will need to compare your latest balance sheet to previous ones to examine how your finances have changed over time.

Then you’ll be able to see how far your business has come since day 1 and whether you’ve been successfully managing cash flow.

The sections of the balance sheet

The balance sheet is made up of 3 parts:

• Assets
• Liabilities
• Shareholders’ equity

The way they are shown on the statement is based on the fundamental accounting equation:

Assets = liabilities + equity

The statement must always balance, hence the name.

That’s because your business has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from you, the owner (issuing shareholder equity).

Let’s look into each section of the balance sheet in more detail.

What are assets?

Assets represent the use of funds.

They are all the things of value that are owned by your business or due to your business.

The business will use cash or other funds provided by either a creditor or investor to acquire assets.

Assets on the balance sheet are listed from top to bottom in order of their liquidity. This is the ease with which you can convert them into cash.

You’ll notice they’re also divided between current assets, fixed assets, and intangibles.

Current assets are those that can be converted into cash in less than 1 year. These include cash in the bank, trade accounts receivable, prepaid expenses, and inventory.

Non-current assets are made up of fixed assets and intangibles.

Fixed assets represent the use of cash to purchase assets whose life exceeds 1 year, such as land, buildings, machinery and equipment, furniture and fixtures, and leasehold improvements.

Intangibles are assets with an undetermined life that may never be converted into cash.

Therefore, for most analysis purposes, intangibles are ignored as assets and are deducted from equity because their value is difficult to determine.

Intangibles consist of assets such as research and development, patents, market research, and goodwill. Intangibles are similar to prepaid expenses because you’re purchasing a benefit that will be expensed at a later date.

What are liabilities?

Liabilities represent sources of cash or its equivalent invested into the business by lenders.

Lenders generally consist of trade suppliers, employees, tax authorities, and financial institutions.

This source of funds enables your business to continue or expand operations.

Liabilities on the balance sheet are split between current liabilities and long-term liabilities.

Current liabilities are obligations that will mature and must be paid within 12 months. They are listed in order of their due date.

These include trade accounts payable, accrued expenses, and current portions of long-term debt.

Long-term liabilities are those obligations that will be payable in the following year(s). This includes the non-current portion of long-term debt and loans payable to owners.

What is shareholders’ equity?

This section represents the owners’ share in the financing of all the assets.

If you add up all of the resources your business owns (the assets) and subtract all of the claims from third parties (the liabilities), the residual leftover is the shareholders’ equity.

This section typically includes 2 key elements.

The first is money contributed to the business. This comes in the form of an investment in exchange for a degree of ownership, typically represented by shares.

The second is earnings that your business generates over time and retains.

How to read the balance sheet

Before delving into the information on your balance sheet, you first need to ensure that it is in balance.

Does the value of your total assets equal the combined value of liabilities and equity?

If they don’t balance, you’ll need to look into the problem.

There may be incorrect or misplaced data, inventory level errors, or exchange rate miscalculations.

Overall, a positive bottom line means there’s value in the company for you as the owner.

A negative balance sheet means there have been more liabilities than assets. There’s no value in the company available to you at that point in time.

Your business can have made a profit for a particular financial year and still have a negative balance sheet if there have been a series of losses in the years prior.

When reviewing your assets, it’s helpful to see the spread between current and non-current.

Are your assets evenly spread or is all the money tied up in fixed assets, for example?

The distribution of your assets can help you identify potential cash flow issues.

When reviewing liabilities, again take a look at the distribution of current versus long-term liabilities for insights into your cash flow.

If you’ve lent money to the company then its largest creditor could well be the shareholder’s loan account.

Another way to extract information contained in the balance sheet is with financial ratio analysis.

The main types of ratios that use the balance sheet are financial strength ratios and activity ratios.

Just be aware that some ratios will need information from more than 1 financial statement.

Financial strength ratios provide information on how well your business can meet its obligations.

For example, the debt-to-equity ratio (calculated as total liabilities / total shareholders’ equity) is a metric that shows the ability of your business to pay for its debts with equity, if the need should arise.

The current ratio (current assets / current liabilities) will tell you whether you have the ability to pay all your debts in the next 12 months.

Activity ratios focus mainly on current assets to show how well your business manages its operating cycle. This includes receivables, inventory, and payables.

These ratios can provide insight into your operational efficiency.

Balance sheet versus cash flow statement versus profit and loss account

The balance sheet shows a snapshot of your assets and liabilities at a specific point in time.

But you’ll notice it doesn’t show the amount of cash that was spent, nor the profit or revenue generated.

This is because the balance sheet doesn’t show your actual financial activity across a period of time.

It only shows the results of what your business owns, and owes, as a result of that activity.

This is why, to get an overall picture of its performance, you’ll need to look across all 3 financial statements.

The profit and loss account will summarize your business revenues, costs, and expenses. This helps you to understand if you were profitable.

The cash flow statement helps you to understand how much cash came in and out of the business during that time and where it was spent.

This statement doesn’t show your business’s financial health as much as give you ideas about where the money is going and potentially how you can budget differently.

Final thoughts

The balance sheet, while only a part of the financial picture, is integral for managing cash flow, understanding how your business is funded, and the value of assets it holds.

Start becoming familiar with the information contained in the balance sheet, and it will unlock plenty of insights into your cash flow management and your ability to pay your obligations as they arise.