You’ve landed on our comprehensive guide to understanding the nuts and bolts of how to read a balance sheet.
Understanding your balance sheet helps you see the clear picture how your hard work and decisions are shaping the financial stability and growth prospects of your business.
Understanding your balance sheet is also related to understanding retained earnings, understanding gross vs. net profit, and understanding owner’s equity.
This guide covers
- Understanding the basic structure of a balance sheet
- Breaking down assets, liabilities, and shareholders’ equity
- Examples of a healthy vs. unhealthy balance sheet
- Balance Sheet comparisons by industry
Let’s get started!
The Basics of the Balance Sheet
First up, assets. These are the resources your business has in its toolbox. Cash in the bank, inventory on shelves, equipment in the backroom—anything your business owns that has value. These assets are the building blocks of your business, the tangible proof of your efforts and investments.
Then, we swing over to liabilities. This side of the balance sheet is all about what your business owes to others. Think loans, credit card balances, or money you need to pay suppliers. Liabilities remind you that not all the resources at your disposal are fully yours to keep; some of them are on loan, and they’ll need to be paid back.
Finally, there’s shareholders’ equity. This is what remains when you subtract liabilities from assets. It represents the net worth of your business, the portion of your company’s value that you and any other shareholders actually own. Think of it as the real, tangible value of your business if you were to settle all debts today.
The Golden Equation
These three elements dance together in what’s known as the accounting equation:
Assets = Liabilities + Shareholders’ Equity.
This isn’t just a formula; it’s the backbone of your financial understanding. It ensures your balance sheet is, well, balanced. Every transaction your business makes will nudge numbers on both sides of this equation, keeping your financial story straight and your strategy on track.
With this foundation in place, let’s dive deeper into each component
Assets
Assets represent the fuel your business runs on. From the cash that flows through your business to the equipment that powers your operations
There are three primary categories of assets: current assets, non-current assets, and an often overlooked yet crucial part, the intangible assets.
Current Assets: Your Business’s Quick Response Team
Cash and Cash Equivalents: The ultimate liquidity, ready to be deployed at a moment’s notice for opportunities or to cover immediate expenses.
Inventory: The products you’ve either produced or purchased, sitting ready for sale. It’s not just stock; it’s potential revenue you haven’t sold yet.
Accounts Receivable: Funds owed to you by customers who’ve bought your products or services on credit. It’s money that should hit your bank account soon, boosting your cash flows.
Prepaid Expenses: Let’s say you pay for a year’s worth of insurance up front. That insurance is actually an asset. Because you haven’t used the insurance yet, that insurance is “owed” to you. You would use 1/12th of that insurance every month, where it becomes an expense and decreases your prepaid asset.
These assets are the heartbeat of your daily operations, supporting your business’s ability to meet its short-term commitments and pursue opportunities without delay.
Non-Current Assets: The Foundation for the Future
Non-current assets, on the other hand, are the long-haul contributors to your business’s potential. They are investments not readily converted into cash but essential for sustained growth.
Property, Plant, and Equipment (PP&E): This category includes the physical assets like land, buildings, machinery, and vehicles. These are the tangible backbones on which your business operates, often subject to depreciation over time, reflecting their wear and use.
Long-term Investments: Investments in other companies, real estate, or bonds meant to yield returns over years, contributing to your business’s financial health and expansion capabilities.
Investing in non-current assets demonstrates your commitment to the future. It’s about laying down the infrastructure and foundation for long-term operations and growth.
Intangible Assets: The Invisible Value Drivers
Intangible assets, while lacking physical substance, are powerhouse contributors to your business’s competitive edge and market value.
Goodwill: Arises when your business acquires another at a price higher than the fair market value of its net assets. It reflects the intangible value gained from the acquisition, such as brand reputation or customer relationships.
Patents and Trademarks: Legal protections for your innovations and brand, granting you exclusive rights to benefit from your creativity and reputation.
Software and Digital Assets: Custom software, websites, and digital tools that enhance your operational efficiency or customer engagement.
These assets, though not always easy to quantify, are critical to certain kinds of companies differentiating their business in a crowded marketplace.
Liabilities
Liabilities are debts. They represent the obligations or debts that your business must fulfill in the future. Let’s break down liabilities into their fundamental categories: current liabilities and non-current liabilities.
Current Liabilities: The Immediate Commitments
Current liabilities are the short-term financial obligations your business needs to settle within a year. They are the pressing dues that demand attention, ensuring your business maintains its reputation and financial stability.
Accounts Payable: These are the amounts you owe to suppliers or vendors for goods or services received but not yet paid for. Managing accounts payable efficiently ensures healthy relationships with suppliers and keeps your business operations smooth.
Short-term Loans: Any borrowings that your business needs to repay within the next 12 months fall here. This could include lines of credit or short-term bank loans, providing the liquidity you need to manage day-to-day operations or unexpected expenses.
Accrued Expenses: These are the expenses your business has incurred but not yet paid, like wages, taxes, and utilities. Accruals ensure that your financial statements reflect all obligations, regardless of when cash transactions occur.
Deferred Revenue: Money received for goods or services not yet delivered. It’s an obligation because your business is committed to fulfilling these orders or services in the future.
Non-Current Liabilities: The Long-term Obligations
Non-current liabilities are your business’s long-term financial commitments, those due beyond the next year. These obligations shape your company’s long-term financial strategy and its ability to invest in growth opportunities.
These long-term loans have a repayment period extending over more than one year. These would include
- Mortgages
- Bank loans
- Vehicle loans
- Equipment financing agreements
- Long term loans to the business from the owner
- SBA Loans (usually)
The Strategic Role of Liabilities
Liabilities are not just hurdles to overcome; they are strategic tools that can be leveraged to fuel your business’s growth. The key is in managing the balance between current and non-current liabilities. This balance ensures that your business can meet its short-term obligations without compromising its ability to invest in long-term opportunities.
Equity
Equity measures the value owners hold in a business. In the context of a small business, equity is the net result of subtracting liabilities from assets, essentially what would remain if all obligations were settled using the company’s assets.
This component of the balance sheet tells a story of investment, ownership, profitability and the financial resilience of your business over time.
Contributed Capital: Contributed capital, or share capital, is the initial amount invested in the business by its owners or shareholders. For small businesses, especially those structured as corporations, this includes the funds you and any partners have put into the company to get it off the ground.
Owner’s Distributions: If a business has enough cash flow, small business owners and partners will usually pull some money out of the business for personal use. Let’s say you had a very profitable quarter and you have plenty of cash in the bank to fund your operations. Take some money out of the business to spend on yourself, you deserve it! That’s Owner Distributions.
Net Income: Your total Net Income for the year is going to sit in the equity section of your balance sheet. Net income is contributing to the value of your company. At the end of the year, your net income gets rolled into cumulative net income, which is retained earnings.
Retained Earnings: Retained earnings are perhaps the most dynamic component of equity, representing the cumulative profits over the life of the business minus any owner’s distributions. Basically, how much profit has remained in the business (meaning you haven’t withdrawn it as a distribution) since you started your company?
Back to the Golden Equation
Remember, Assets = Liabilities + Equity.
Your Assets and Liabilities will always be positive numbers on your Balance Sheet. But your Equity could be a negative number, because the sum of Liabilities and Equity must equal Assets.
If you have very few assets, a lot of debt, haven’t turned a profit in your business, and have pulled money out of the business as the owner’s draw, you’re going to have negative equity.
Examples for reading a balance sheet
Let’s consider two small businesses to illustrate the concept of a healthy vs. unhealthy balance sheet. We’ll use “Lakeside Café,” a thriving local coffee shop, and “Gadget Garage,” a struggling electronics repair shop.
Lakeside Café: “Good” Balance Sheet
Assets
- Current Assets: $75,000
- Cash: $20,000
- Accounts Receivable: $5,000
- Inventory (coffee beans and bakery items): $10,000
- Prepaid Expenses: $40,000 (insurance and rent)
- Non-Current Assets: $125,000
- Property (café and kitchen equipment): $100,000
- Intangible Assets (brand value and recipes): $25,000
Liabilities
- Current Liabilities: $30,000
- Accounts Payable: $15,000
- Short-term Loan: $15,000
- Non-Current Liabilities: $70,000
- Mortgage on Property: $70,000
Equity
- Contributed Capital: $50,000
- Retained Earnings: $50,000
Analysis: Lakeside Café shows a strong balance sheet with healthy liquidity, as seen in its solid cash position and manageable accounts receivable. The café’s inventory is realistic for its business model, and its significant prepaid expenses demonstrate forward-thinking management.
The liabilities are well structured, with a long-term mortgage indicating investment in permanent assets. The equity position shows a good balance of owner investment and profits being reinvested into the business for growth.
Gadget Garage: “Bad” Balance Sheet
Assets
- Current Assets: $20,000
- Cash: $5,000
- Accounts Receivable: $10,000 (aged receivables, indicating slow collection)
- Inventory: $5,000 (outdated gadgets and parts)
- Non-Current Assets: $30,000
- Equipment: $30,000 (depreciating quickly due to technological obsolescence)
Liabilities
- Current Liabilities: $40,000
- Accounts Payable: $25,000
- Credit Card Debt: $15,000
- Non-Current Liabilities: $10,000
- Long-term Loan: $10,000
Equity
- Contributed Capital: $10,000
- Retained Earnings: -$10,000 (indicating losses)
Analysis: Gadget Garage’s balance sheet is concerning, highlighting several red flags. The low cash reserve paired with slow collection means the business could run out of cash fast. The inventory of outdated parts may not be easily sold, further stunting cash flow.
High current liabilities, especially credit card debt, means the business is having trouble paying it’s vendors and creditors. The negative retained earnings could either mean that the business is not profitable, or the owners have pulled too much money out of the business for personal use, or both.
Reading a balance sheets across industries
When reading a balance sheet, it’s crucial to remember that not all industries are created equal. Financial benchmarks and expectations can vary significantly from one sector to another, making it essential to compare businesses within the same industry.
Let’s explore how healthy balance sheets might differ by industry and why it’s important to compare apples to apples.
Retail Industry: Inventory-Intensive
In the retail sector, a healthy balance sheet often features a high volume of current assets, primarily due to inventory. For example, a successful clothing store might show a higher proportion of its assets tied up in inventory compared to a service-based business. When comparing retailers, assess how effectively they manage inventory levels and turnover rates, as too much inventory can tie up cash and lead to inventory going obsolescent.
Manufacturing Industry: Capital-Heavy
Manufacturers typically have significant non-current assets, including machinery, equipment, and facilities necessary for production. A healthy balance sheet in this industry shows a solid investment in these long-term assets while maintaining enough liquidity to cover short-term obligations. They may also have significant long-term liabilities like mortgages on factories and equipment financing.
Service Industry: Labor-Dependent
Service-oriented businesses, such as consulting firms or digital marketing agencies, may have a vastly different balance sheet composition. They tend to have lower levels of tangible assets and higher current assets, reflecting a focus on receivables and cash. A healthy service industry balance sheet often shows strong cash flow management and minimal debt, as the business model relies less on physical assets and more on human capital.
Technology Industry: R&D and Intellectual Property
For tech companies, especially startups, a healthy balance sheet might look unconventional, with significant investments in research and development (R&D) and intangible assets like patents and software. These companies may operate at a loss while investing heavily in future growth, making traditional metrics like debt-to-equity ratios less useful. Instead, evaluating a tech company’s balance sheet requires a focus on potential future revenue streams from its intellectual property and the scalability of its business model.
Pulling it all together
Reading a balance sheet starts with a simple equation:
Assets = Liabilities + Equity
Now you should understand the various kinds of assets, liabilities, and equity that make up a balance sheet, and how they relate to each other to form a clear picture of how healthy a business is.
Pat yourself on the back! Mastering the balance sheet is empowering! It allows you to track your company’s progress, identify financial strengths and weaknesses, and make strategic decisions with confidence. Embrace this tool, and it will guide you through managing debt, optimizing assets, and ultimately, driving your business towards sustainable growth and success.
How Rigits can Help
At Rigits, our goal is to lighten up the path to your business’s success. We have two goals when it comes to helping you understand your balance sheet.
- We’ll make sure your balance sheet is clean and accurate. Our motto is “Books so clean you could eat off them”
- We translate the language of assets, liabilities, and equity into plain English, giving you the power to make smart decisions with confidence. We help you not only produce and read your balance sheet, but improve it!
Let us handle the heavy financial lifting, so you can get back to what you love growing your business. With Rigits, financial clarity is just around the corner. Ready to turn those financial frowns upside down? Let’s chat!
Next, check out our articles on how to calculate burn rate, how to do bank reconciliations, and understanding journal entries in accounting.
FAQ: How to read a balance sheet
Here's some answers to commonly asked questions how to read a balance sheet.
What does a balance sheet show?
A balance sheet provides a snapshot of a company’s financial health at a specific moment, detailing what the company owns (assets), owes (liabilities), and the equity value belonging to the shareholders. It’s a crucial financial statement that offers insight into the company’s stability, liquidity, and overall financial position.
By comparing assets against liabilities, you can gauge whether the company is capable of covering its debts and how effectively it’s using its resources to fuel growth.
Why is the balance sheet important?
The balance sheet is fundamental for several reasons: it helps stakeholders assess the company’s financial stability, liquidity, and operational efficiency. For business owners, it’s a tool for making informed decisions about spending, investing, and financing.
Investors use it to determine a company’s health and its potential for future profitability. Creditors assess it to evaluate the risk of lending. Essentially, it’s a financial mirror reflecting the company’s worth and sustainability, guiding strategic planning and financial management.
How often should I review my balance sheet?
Regular review, at least on a monthly basis, is recommended to stay informed about your business’s financial status and to make timely adjustments. This frequency ensures you’re up to date with your company’s liquidity, asset management, and debt obligations, allowing for proactive financial planning and decision-making.
For small businesses, this can be crucial for spotting trends, addressing issues before they become problematic, and seizing opportunities to improve financial health and growth.
