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What is a balance sheet and how do I read it?

Every business needs three fundamental financial statements: an income statement, a cash flow statement and a balance sheet.

The balance sheet in particular is an invaluable tool. It shows your business’s net worth and overall financial health, by recording your assets, liabilities and shareholder’s or owner’s equity.

How to read a balance sheet

Once you are adept at reading your business’s balance sheet, it will allow you to track your business’s performance accurately, optimise your finances and even grant you access to funding, loans and other forms of credit.

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What is a balance sheet?

A balance sheet is a financial statement used in accounting. It includes three main ingredients: your assets, your liabilities and the shareholders’ equity.

In other words, it records what you own (assets) and who owns it – either a third party like a bank (liability) or the company and its shareholders (equity).

Balance sheets give you the most accurate view of the financial value of your business, taking all current assets and even pending liabilities into account.

Balance sheets aren’t compulsory for all businesses; only publicly-trading companies are actually required to have them.

But if you are a sole trader or small company, even though you aren’t legally required to have a balance sheet for tax or regulatory purposes, you may find them very useful to provide a clear overview of your financial status.

How does a balance sheet work?

A balance sheet uses one simple, fundamental formula:

Assets = Liabilities + Shareholder’s Equity

Under assets, you’ll record everything your business owns, from cash in the bank to equipment and property (more detail on this below).

Under liabilities, you’ll record what you need to pay, including loans, wages and taxes. And under shareholder equity, you’ll record things like common stock and retained earnings.

For your statement to balance (hence the name), your total assets must always be equal to your liabilities plus equity.

If these two numbers aren’t the same, then either something in your accounting system has gone wrong or there’s a serious problem (such as a cash flow issue) that could quickly lead to insolvency.

What’s the difference between a balance sheet and an income statement?

A balance sheet has some similarities to an income statement (also known as a profit & loss account).

Both report on revenue and expenses, but a balance sheet is a broader summary of your business’s overall financial position.

It looks at every asset, liability and shareholder equity at a specific point in time. An income – or profit & loss – statement focuses on what you’ve bought and spent over a certain period of time.

You might, for example, draw up an income statement every month for budgeting purposes, which won’t take your longer-term liabilities into account like a balance sheet does.

Why is it important to have a balance sheet?

A balance sheet benefits you in more ways than one: it can also be a great tool for attracting investors and lenders.

If you compile them regularly, you’ll have a snapshot of how your business is currently performing, how it’s performed in the past, and how you can expect it to perform in the future.

For investors, stakeholders or regulators, this – coupled with your income statement – can inspire a lot of confidence in your business.

They’ll be able to see how you manage debt, how you turn assets into revenue, how well you generate returns, and how much leverage you have. Conversely, if you don’t have these documents then you are very unlikely to secure investor confidence or bank finance.

Now let’s look in more detail at the components that make up a balance sheet: assets, liabilities and equity.

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What are assets?

When using a balance sheet, you’ll record all your assets in the first column. An asset is anything of value that your company owns.

Assets are grouped into two categories: current assets and non-current assets.

Current assets are cash or cash equivalents which could be easily converted into cash in one year or less. You’ll list these on your balance sheet first, and they include:

  • Accounts receivable: This is money that customers owe you
  • Inventory: These are any items, goods or merchandise that you sell to earn a profit
  • Marketable securities: These are investments that can be easily bought, sold or traded
  • Prepaid expenses: If you’ve paid for goods or services in advance, like rent or insurance, this is considered an asset until it’s used up or expires.

Non-current or long-term assets are those which won’t realise their full value within a financial year.

These include tangible fixed assets like land, buildings, machinery and equipment – anything that required a significant amount of capital investment.

They can also include intangible assets like patents, licences and intellectual property, but only if you acquired them and didn’t develop them yourself.

Because non-current assets are longer-term investments, you’ll always factor depreciation into the balance sheet.

What are liabilities?

Any money you owe to an outside party, whether they’re a creditor or supplier, is considered a liability.

In a balance sheet, you’ll record your liabilities in the second column, next to your assets.

Similar to assets, there are current liabilities and long-term liabilities.

Current liabilities include anything payable within a year, including:

  • Portions of your debt
  • Overdrafts
  • Interest
  • Wages
  • Taxes
  • Rent
  • Utilities
  • Accounts payable (money you owe suppliers for goods or services bought on credit)

Long-term or non-current liabilities include things you cannot pay off within a year, like bonds payable and long-term debts or interest (i.e. the total amount of debt minus what you’ll be paying in the current year).

What is equity?

Equity – often called shareholder or owner’s equity on a balance sheet – represents two things.

First, it includes the amount funded by the owners or shareholders of a company for the initial start-up of the business. It also includes the money attributable to the business owners after liabilities.

In other words, equity is the value left after subtracting liabilities from assets. In this way, it’s similar to the equity you have when you own a home with a mortgage: the equity is the proportion of the property that you own outright.

On a balance sheet, equity will be recorded underneath liabilities.

Equities can include:

  • Common stock: Represents a share of ownership in a company. This value increases or decreases based on business performance.
  • Preferred stock: This is similar to common stock, except the stockholder will have priority over common stockholders when it comes to a company’s income.
  • Additional paid-in capital: This is the value of a company’s shares above the value at which they were issued.
  • Retained earnings: This is the net income left after the business has paid out dividends to its shareholders. This profit can be paid out to shareholders or re-invested back into the business for growth.

I’m a small business owner – do I need an accountant to file my balance sheet?

Balance sheets can be intimidating, especially if you’re not familiar with accounting. It’s worth enlisting the help of an accountant, either to get you started or to save you the time and hassle of doing them.

Accountants can help you identify what classifies as an asset, liability and equity. Furthermore, if you’re having trouble balancing your statement, they can look for any errors, miscalculations or missing data.

Balance sheets are something that every small business deserves to get right, as a small error can quickly magnify over time. Here’s a guide on accountant costs to give you an idea of what to expect.

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About the author
Nick Green is a financial journalist writing for Unbiased.co.uk, the site that has helped over 10 million people find financial, business and legal advice. Nick has been writing professionally on money and business topics for over 15 years, and has previously written for leading accountancy firms PKF and BDO.