5 Balance Sheet Secrets You NEED to Know Now!

The Balance Sheet is arguably the most important financial statement that you need to know about. It’s my personal favorite, if there is such a thing.

While your bookkeeper or accountant is trained to read the financial statements, many small business owners are not, and that’s why I’m writing this blog article. 

I’ll share with you 5 things to know about the Balance Sheet. And show you why it’s the most important financial statement.

In simple terms, Financial Statements are documents that show the financial status and performance of a business.

It consists primarily of the Balance Sheet, Profit and Loss Statement, and Statement of Cash Flows.

 #1 Why is the Balance Sheet the Most Important Financial Statement?

Investors would argue that the Statement of Cash Flows is the most important financial statement. Managers or business owners might argue that the Profit and Loss Statement is the most important financial statement, but as a former internal auditor, I can tell you that during a financial audit, auditors audit the Balance Sheet.

An audited financial statement is any financial statement that an independent auditor has audited and expressed an opinion, whether or not a financial statement is fairly stated, free from material misstatement, and conforms to generally accepted accounting principles.

Without this, investors, or lenders would not be confident that they could actually rely on the financial statement.

To use an expression, if there are dead bodies to be found, you’ll find them on the balance sheet. Put another way, if you know the balance sheet is right, then the profit and loss statement is right. The logic doesn’t work the other way around.

Whether or not you can fully agree with me, just keep an open mind for now.

#2 What Is a Balance Sheet and What Is Its Purpose?

To understand the Balance Sheet better, first, let’s discuss its definition and its purpose.

The balance sheet reports on a company's assets, liabilities, and owner’s equity at a specific point in time. All of this is a reflection of a business’ overall financial health.

Basically, the Balance Sheet provides a snapshot of what a company owns and owes. It can help to assess risk. It can also show you how well the company is performing.

The Balance Sheet also shows the financial position or the net worth of your business, also called the book value.

Book Value = Assets - Liabilities

The Purpose of a Balance Sheet

The balance sheet serves many purposes depending on who’s using them.

If it’s used by the business owner, it gives you insights into how well your business is doing. Like whether it’s succeeding or failing.

You can compare your latest balance sheet with previous periods and you'll be able to see how the financial position has changed over time.

If a balance sheet is used externally by investors or lenders it provides them with information on what the business owns, how the business is financed, its profitability, and whether it can meet current and future obligations.

This information can help them to decide if it would be wise to invest or lend money to your business.

Now that you have a basic understanding of what the Balance Sheet is and its purpose, let's move on.

#3 What Are the Main Components of a Balance Sheet?

As mentioned, a Balance Sheet has 3 main components: Assets, Liabilities, and Owner’s Equity.

The relationship can be best explained with what’s called, The Accounting Equation.

ASSETS = LIABILITIES + OWNER'S EQUITY

A balance sheet must always balance. Hence the name ;)

Assets are defined simply put, as anything owned or controlled by the business that is expected to provide an economic benefit.

Put another way, assets are valuable because they can generate revenue or be converted into cash. They can be cash in bank accounts, physical items, such as vehicles or machinery, or intangible items, such as intellectual property.

Here is a sample of a Balance Sheet for a small business (see video).

Notice that the assets are presented in order of liquidity or how soon it would usually take to convert them into cash.
 

It is subdivided into current and non-current assets.
 

Current Assets are assets that we expect to be converted into cash within a year.
 

The most common current assets accounts are:

Cash and Cash Equivalents

You may have noticed that Cash is always presented at the top because this is the most liquid asset. Cash consists of your cash balances in your bank accounts, and cash on hand.

Cash Equivalents, are short-term, liquid investments that can be readily converted to cash. Examples of these would be like money market accounts, and CDs or certificates of deposit.

Other typical accounts under current assets that you're probably already familiar with, are Accounts Receivables, Prepaid Expenses, Inventory, etc.

Allow me to elaborate on Prepaid Expenses. These are expenses that are paid in advance such as maybe rent, or insurance, where the coverage extends into the future. You wouldn’t want to expense all of it right away, since it wouldn’t properly match up with the economic activity. So that’s why prepaid expenses are booked as an asset and expensed over time, as they’re used up. 

Non-Current Assets

Assets that don't qualify as current assets generally fall under non-current assets. These are longer term assets that aren’t expected to be liquidated within a year. Non-current assets typically include Long-term Investments, Fixed Assets, like Machinery and Equipment, and Intangible Assets.

Long-term investments are any investments generally held for more than one year, such as stocks, bonds, mutual funds, real estate, etc.
 

Fixed Assets are long-term assets such as land, buildings, leasehold improvements, vehicles, furniture & fixtures, machinery and equipment, etc.

Intangible Assets

Examples of these include patents, trademarks, copyrights, and goodwill arising from business acquisitions.

Liabilities

Which is the second big component of a balance sheet. Remember the accounting equation, Assets = Liabilities + Owner’s Equity.
 

In simple terms, a liability is any money a business owes to other parties, such as suppliers, creditors, lessors, utility companies, employees, etc.

Liabilities are listed in the balance sheet in order of their due date or how soon they are expected to be paid.

Current Liabilities are things like short-term loans like credit cards, due within one year.

Customers' prepayments or Unearned Revenue is also a current liability. These are advance payments made by your customers for a product or service that has yet to be delivered or provided. Maybe you presold merchandise, so the sales would be recorded as a liability since the actual sale exchange hasn’t taken place yet.
 

Some other common accounts that you can find under Current Liabilities are Accounts Payable, Rent Payable, Taxes Payable, Wages Payable, etc.

Non-Current Liabilities
 

Any Liabilities that do not qualify under Current Liabilities are classified under Non-Current Liabilities. These are long-term liabilities, such as Loans Payable, Loans from Owner’s, etc.

#4 How to Understand the Equity Section of the Balance Sheet?

If you recall the accounting equation previously mentioned, we know that

OWNER'S EQUITY = ASSETS - LIABILITIES

Based on this, we can say that the Owner's Equity is what's left over for the owner or owners, after you've deducted all the liabilities from all the assets.

Owner's Equity represents the owner's investment in the business plus net income (or minus a net loss) and less an owner's withdrawals.
 

Typical equity accounts for a sole proprietor would be, Owner’s Capital, Owner’s Draws or Distributions, and Retained Earnings, which also factor in the current period income or loss.

Retained Earnings tracks a company’s cumulative net earnings or profit.
 

By looking at the balance sheet alone, you can know the financial condition of a company, how well it’s capitalized, to what extent are there liabilities, how well the company has done over the years, and how well it’s doing in the current period.

#5 What Are KPIs and Why Are They Important?
 

Management, investors and creditors, use these Balance Sheet ratios or KPIs (Key Performance Indicators) so it's important to have a general understanding on what they are and how they’re calculated.
 

To gain insights into your business' financial health, we can calculate KPI ratios to determine things like liquidity & solvency.
 

Liquidity measures how quickly a business can pay off its short-term obligations, and it’s ability to sell assets to raise cash. While Solvency is the ability of a company to meet its long-term debts and continue operating into the future.
 

Some of the ratios used to determine liquidity are the Current Ratio, and Quick Ratio.

The Current Ratio (also known as the Working Capital Ratio)
 

How do you know if a company has enough cash and short-term assets on hand to pay bills in the short term? Well, by taking the current assets divided by current liabilities on a balance sheet, you can determine a company's current ratio. This ratio is simply calculated as follows:

Current Ratio = Current Assets / Current Liabilities

Analysts generally consider a ratio of 1.5 to 2 or higher as adequate. Although, it really depends on the industry and and the specific business. A higher ratio may signal that the company is accumulating cash. If the current ratio falls below 1, a business may be in danger of not being able to pay its short term liabilities. 

As an example, a current ratio of 2 means the business has 2 times more current assets to cover its current liabilities.

The Quick Ratio
 

This ratio is similar to the current ratio, but is more conservative. It subtracts inventory from current assets because it considers inventory as a less liquid asset because it takes longer to sell, and it may need to be discounted in order to liquidate.

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

A quick ratio below 1 may not be good, it could mean the company may not have enough liquid assets to cover its current obligations.
 

Your Net Working Capital is the capital a business has available to use in its day-to-day operations. It tells you how much money is readily available to meet current expenses.
 

The difference between current assets and current liabilities determines a company's working capital:

Working Capital = Current Assets - Current Liabilities 
 

Generally, a positive net working capital figure is desirable.

Debt to Equity Ratio

One of the most important ratios derived from a Balance Sheet is the debt-to-equity ratio, which is calculated as … total liabilities divided by shareholders’ equity.
 

Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders' Equity
 

This ratio tells you how dependent a business is with using debt in the company. It’s essentially, a ratio of what is owed to what is owned. For most businesses, a lower ratio is viewed more favorably. Although it really depends on the type of business.

That wraps up the 5 things to know about the balance sheet. Thanks for reading and see you in the next blog post!