Balance Sheets: What Are They and Why Are They Important?

A balance sheet is a financial statement that provides a snapshot of a company’s financials at a specific time. Also known as a statement of financial position, a balance sheet shows what the company owns that can be converted to cash (assets), its debts and financial obligations (liabilities), and its net worth (owner’s equity or shareholder’s equity). By knowing the current balance of these three elements, a company can gauge its overall financial health. These numbers help you

• know how much cash is currently available,
• calculate the company’s debt-to-equity ratio and other financial ratios,
• see how the company’s finances have changed over time, and
• compute the company’s book value.

A balance sheet—along with an income statement, cash flow statement, and statement of retained earnings—is one of the four basic types of financial statements. Bookkeepers or accountants typically prepare balance sheets, but in small businesses, the owner may be in charge of the balance sheet.

Elements of a Balance Sheet

Balance sheets are prepared at the end of a set reporting period, such as monthly, quarterly, or annually. For public companies, balance sheet requirements are stricter. They must be reviewed by public accountants in accordance with generally accepted accounting principles (GAAP) and regularly filed with the Securities and Exchange Commission (SEC). Nonpublic companies do not need to comply with these requirements, but for small businesses, accurate balance sheets are no less important.

A balance sheet has two columns: one on the left depicting assets and one on the right depicting liabilities and owner’s equity. The following are the specific values that are accounted for in the balance sheet columns:

• Assets: Anything a company owns that can be sold for cash (i.e., has a dollar value) is considered an asset. On a balance sheet, assets should be broken down into current and long term, or noncurrent, assets.
  • Current assets are assets that can be converted into cash in a year or less. They include not only actual cash and cash equivalents, but also accounts receivable, inventory, prepaid expenses (e.g., office rent), and marketable securities (high-liquidity short-term investments).
  • Long-term assets, also known as fixed assets, are investments a company makes that they do not expect to convert to cash within a year. Buildings, equipment, land, machinery, intellectual property, and long-term securities are examples of noncurrent assets.
• Liabilities: Whatever a company owes to a debtor counts as a liability on the balance sheet. Like assets, liabilities are further broken down into current and long term.
  • Current liabilities include debt and interest payments on short-term loans, payroll, accounts payable, credit card debt, rent, and other debts expected to be paid within the next year.
  • Long-term liabilities are debts not expected to be paid in full in the next year, such as bonds payable, long-term loans, and leases.
• Shareholders’ equity represents the amount left over if the company converted all assets to cash and paid all liabilities (i.e., its total net worth). Increasing owner equity is a sign of good business health, while declining equity might indicate that changes should be made, such as paying down debt and reducing liabilities. Equity belongs to the business’s owners and includes capital, stock (public or private), and retained earnings, minus any drawings, including draws for business owner compensation. The following is a simplified way of expressing this:

Shareholders’ Equity = Total Assets – Total Liabilities

On your balance sheet, the assets on the left side should always equal the liabilities and equities on the right side. In other words, company assets are equal to its liabilities, plus any owner’s equity. A company with more assets than liabilities has positive net equity, while a company with more liabilities than net assets has negative equity.

Balance sheets should always balance. A balance sheet that is out of balance has issues that need to be corrected. Common culprits are bad or missing data, data entry errors, and incorrect calculations.^[1]

What a Balance Sheet Reveals About a Business

If your balance sheet is in balance, it provides an up-to-date overview of how the company is performing financially. You can glean the following insights about your business from its balance sheet:

• The amount of cash that is readily available (liquidity)
• Your ability to pay for current expenses (working capital)
• How efficiently assets are being used to generate revenue
• How leveraged your business is based on the debt-to-equity ratio
• Whether the business has a positive or negative net worth
• Indebtedness relative to competitor businesses
• What you own and how much you owe

How a Balance Sheet Is Used

Although a balance sheet is a snapshot of a particular reporting period, you can compare balance sheets from different periods to see how your finances have changed over time. Public companies can also use their balance sheets as a benchmark against their peers since this information is publicly disclosed.

The information in a balance sheet is valuable to business owners and outside parties like lenders and investors. For example, banks will look at a company’s balance sheet and other major financial statements during the loan application process. Similarly, investors will want to see your balance sheet as part of a risk assessment before putting money into your business. If you decide to sell your business, the balance sheet helps potential buyers to assess its financial position. In addition, C corporations are required to submit a balance sheet as part of their annual federal income tax return.

Professional Balance Sheet Preparation

You do not have to be a professional accountant to accurately prepare a balance sheet. Small business owners may be responsible for balance sheet preparation when the company is starting out. However, business owners should ask themselves whether they are well-suited to this task, or if it is the best use of their time. Balance sheet preparation gets more complicated as the business grows and diversifies.

A professional bookkeeper or accountant may be the better way to go. Having a person with the necessary financial knowledge and experience, who is dedicated to doing all your financial statements, can make sure that everything is accurate. A professional can additionally help you maximize tax exemptions, improve financial health, and free up your time to focus on business growth.

We can help you form a team of professionals that can provide a full suite of services to your small business and take a big picture approach that harmonizes financial, legal, and administrative strategies. For help with your small business, please contact us to schedule an appointment.