A balance sheet is a report that gives you a snapshot of the financial health of your business. Unlike a profit and loss statement, which shows you what you’ve earned and spent in a given time period, a balance sheet shows the whole picture of your finances.
A balance sheet lists your total assets (what you own), total liabilities (what you owe others), and equity (what part of the business you personally own) at any point in time.
Why are balance sheets important?
Reading a balance sheet can help you answer overarching financial questions like:
- How much liquid assets does my business have? In other words, if I needed $X right now, do I have access to it?
- Is my level of debt sustainable given my current operations?
- How much is my business worth?
A balance sheet can also help you answer cash flow questions like:
- How much money do others owe me that will be paid in the near future?
- How much money do I owe others that needs to be paid in the near future? Do I have the cash available to cover these obligations?
- How much money is available after paying my current liabilities to put back into my business (aka what’s my working capital)?
Finally, a balance sheet is often used by lenders and investors to see:
- The financial risk of investing in your business. If your company has more liabilities than equity, it appears riskier.
- If the business is becoming more or less solvent over time. Is the debt-to-asset ratio increasing or decreasing?
- How much money is paid out to shareholders and owners or reinvested in the business?
See? The profit & loss report isn’t the only cool kid on the block!
How is a balance sheet structured?
A balance sheet has three main sections:
- Assets
- Liabilities
- Equity
At the very bottom of your balance sheet, you’ll see a line that says Total Liabilities and Equity. Which, you may notice, is the same as your Total Assets.
That’s because a balance sheet needs to…balance! All of the money in your business needs to be accounted for through the basic accounting equation:
Assets = Liabilities + Equity
Unlike a profit & loss report, which shows your net income on the final line, the last line of the balance sheet shows that your accounting is indeed, balanced. If you add up your liabilities and equity and they don’t equal your total assets, that means there’s a serious problem in your accounting that needs to be addressed.
Because a balance sheet doesn’t add up or subtract your financial activities over time, it really is a snapshot of your current financial standing. (That’s why a balance sheet is also called a statement of financial position.) Think of it as a really detailed list of everything that you own and everything you owe, right now.
Got it. Tell me more about how to read a balance sheet.
Assets
The first section of a balance sheet shows your assets. Assets are everything that your business owns.
There are two types of assets: current and non-current.
A current asset is anything that can be converted to cash within 12 months. Sometimes you’ll hear this called a liquid asset. A non-current asset is something your business owns that takes longer to convert to cash, also referred to as an illiquid asset.
The assets section of your balance sheet is organized from most liquid assets to least liquid assets. That is, the assets that can be most readily turned into cash (like money in your bank account) appear at the top. Assets that take longer to convert to cash (like land that you own) appear towards the bottom.
Current Assets
There are three main types of current assets:
- Cash
- Inventories
- Accounts receivable
Cash is, you guessed it, the money you have in your bank account. The balance that you have in your bank account on the date of the balance sheet is what appears on the balance sheet.
Inventories are items that you have available to sell. If it’s sitting on the shelf in your boutique, it’s going to appear as an asset on your balance sheet. Depending on the accounting method you use, raw materials may also appear as an inventory asset.
Accounts receivable is money that is owed to you from your customers. If you invoice someone for $1,000 and they have 30 days to pay you, that $1,000 appears on your balance sheet as accounts receivable until the invoice is paid.
Other types of current assets are:
- Undeposited funds (money that has been paid to you but has not been deposited into your bank account)
- Short-term investments
- Stocks
- Prepaid expenses
- Short-term loans to others
Non-current assets
After the current assets section, you’ll see your non-current assets. On a balance sheet, non-current assets appear under the following headers:
- Investments (these are long-term investments that cannot be converted to cash in the next 12 months)
- Fixed assets (for example, property, equipment, vehicles, machinery, and leasehold improvements)
- Intangible assets (for example, trademarks, patents, domain name, brand name, etc.)
- Other assets
When looking at your balance sheet, it’s important to pay attention to more than just your total assets. You should also look at how much of your assets are current versus non-current.
For example, if you have $50,000 in total assets, that might feel like a lot. But if only $5,000 is in current assets, that means that your business doesn’t have a lot of cash readily available.
Liabilities
The second section of your balance sheet shows your liabilities. A liability is anything that your business owes to others. And just like assets, there are two kinds of liabilities: current and long-term.
Current liabilities are debts that can be settled in the next 12 months. Long-term liabilities are debts that will be settled in more than 12 months.
And, surprise surprise, the liabilities section of your balance sheet is ordered from your most current liabilities to the most long-term ones.
Current liabilities
At the top of the liabilities section are your current liabilities. Common current liabilities include:
- Accounts payable
- Short-term loans
- Credit card balances
- Other payables
Accounts payable is money that you owe others. Usually, this is money that you owe for goods or services that you’ve received but not paid for yet. If you work with vendors who give you a certain number of days to pay your invoice, then you have accounts payable.
Short-term loans are loans that you expect to pay back within one year. A common example is a business line of credit. You borrow that money when you need it and then pay it back within a few months.
Then there are credit cards. Because credit card spend is supposed to be paid back quickly, they are among the most current of your liabilities.
Other payables is a broad category that encompasses money that you may owe to various government agencies within the next 12 months. It’s money that should be considered “set aside” for payments that you’ll eventually need to make.
Examples of other payables are:
- Sales tax payable
- Payroll taxes payable
- Income taxes payable
Long-term liabilities
Next, you’ll see your long-term liabilities. These are debts that cannot be paid in full in the next 12 months.
Examples of long-term liabilities are:
- Business loans with terms longer than 12 months
- Tax liabilities (for example, if you’re on an IRS payment plan for taxes owed from previous years)
- Mortgage on a building or property
Just like it’s important to differentiate between current and non-current assets, it’s important to know the amount of your current liabilities and long-term liabilities.
Your current liabilities are your immediate concern as this debt needs to be paid in the next 12 months. Your business needs to make enough money to cover these payments while also continuing to make payments on your long-term liabilities.
Knowing your total long-term liabilities can also help you plan your future payments and understand how long you’ll be making payments for.
Equity
The last section of your balance sheet is the equity section.
It shows your share of the business’s total assets. In other words, how much money you would receive if all the business’s assets were liquidated and liabilities paid off. This is often referred to as the net worth of your business.
Here’s an easy way of thinking about equity:
Equity = Total Assets – Total Liabilities
If it’s a positive number, you have more assets than liabilities. If it’s a negative number, you have more liabilities than assets.
Just like assets and liabilities, there are different types of equity on a balance sheet. The most common are:
- Owner’s draw or Shareholder distribution or Dividend payments
- Owner contribution or Shareholder contribution or Paid in capital
- Net income
- Retained earnings
Owner’s draw can also be called shareholder distribution, partner distribution, or dividend payment, depending on the type of business that you have. Whatever it’s called, it’s referring to the same thing—how much money the owner(s) have taken out of the business over time.
Owner contribution, shareholder contribution, and paid in capital also all mean the same thing. It’s the money that the owner(s) have put into the business over time. This is either through cash investments (like giving your business $5,000 cover its expenses) or assets that you contribute to your business (like a laptop you’ve already paid for).
Net income is the amount of money that your business has earned after its costs and expenses. It’s your total gross income minus your costs and expenses. In other words, your business’s profit.
Retained earnings is the business’s profit that’s not taken out of the business by the owner, but rather left in the business for reinvestment. For example, if your business profit is $100,0000 and your owner’s draw is $30,000, then your retained earnings for that accounting period is $70,000.
When many people look at the equity section of the balance sheet, they’re looking at the very last line, the total equity, to see the net worth of their business. But looking closer at this section will also show you how and why your equity is growing.
Is it growing because you’ve invested more of your money in your business? Or is it growing because the business is making more money and spending less, leading to increasing profits? The latter means your business is being financed through its own operations rather than your personal contributions.
How do I prepare a balance sheet, and how often should I review one?
You can use a digital accounting program like Xero to prepare a balance sheet, or you can hire a bookkeeper to do it for you.
Rather go the DIY route? You can also prepare your own using this balance sheet template.
While there’s no hard and fast rule about when you need to prepare and review a balance sheet, many accountants and bookkeepers suggest doing so every quarter, or at least at the end of your fiscal year, as a best practice.