A balance sheet is one of the most critical corporate financial documents, yet many business owners don’t fully understand the “what,” “how,” and “why” behind it. As a result, many small businesses fail to maximize their purpose and potential, particularly those in the early stages of development.
The reality is, balance sheets are critical to your financial success, no matter what the size of your organization, allowing you to plan for the future of your business and mitigate risk. Our goal with this article is to make understanding of what they are and how to use them as simple as possible.
Let’s start with the basics.
What is a Balance Sheet?
A balance sheet is a summary, at a point in time, of assets (what a company owns), liabilities (what a company owes), and shareholder equity. It is a snapshot and, as such, does not offer insight into trends over more extended periods. Instead, the balance sheet must be compared with those of previous periods to understand shifts and changes over time.
On a balance sheet, you will see a breakdown of all three categories of financial information. You will also see those categories come together in the form of an accounting equation:
Assets = Liabilities + Shareholder Equity
This may seem counterintuitive. After all, shouldn’t shareholder equity be a matter of subtracting liabilities from a company’s assets?
But think of it this way: A company pays for its assets in one of two ways:
- By borrowing money (taking on additional liabilities)
- Or raising capital by selling ownership shares (stock) to investors.
That means an increase or decrease on one side would equate to an increase or decrease on the other.
Here’s an example:
Say your company takes out a loan from the bank for $10,000. As a result, your assets will increase by $10,000. So will your liabilities because you’ve added a new loan to your balance sheet—the two sides of the equation balance each other out. The same goes if your company raised that $10,000 from investors. Your assets would increase by $10,000, as would your shareholder equity, once again creating balance.
There are a lot of ratios and other indicators that financial professionals use when evaluating a company’s balance sheet, but most of the time it's as simple as making sure what a company owns is more than what it owes and ensuring the organization has the liquidity in the short term to pay its debts in a timely fashion.
Breaking Down the Balance Sheet
Now that you have a broad understanding of a balance sheet, let’s dig into the details, starting with assets.
Assets
The assets section of a balance sheet is typically divided into current assets and non-current assets.
Current assets are those that can be converted to cash within the next 12 months. For example, accounts receivable are considered current assets because they should be collected as cash within 12 months. Conversely, accounts payable is considered a current liability as the amount will be paid to the vendor out of the company’s cash balance within the next 12 months.
Non-current or long-term assets cannot be converted into cash within the next 12 months, including fixed and intangible assets. Fixed assets can be anything from machinery and equipment to land, buildings and other typically capital-intensive assets. As the name would imply, intangible assets are not physical assets like a machine or a building, but they are no less valuable. These assets include things like intellectual property and goodwill.
A balance sheet typically lists these assets in order of liquidity, or how easy it is to convert them to cash, so current assets come first, followed by non-current and intangible assets.
Liabilities
Liabilities on a balance sheet are divided similarly into current and non-current liabilities.
Current liabilities are those that are due to be repaid within 12 months. This can include accounts payable, wages and benefits for employees, and customer prepayments. It can also include portions of long-term debt, if a certain portion is due within the next year.
Non-current or long-term liabilities are due at any time after 12 months. Examples of long-term liabilities include long-term debt, deferred tax liability, and even pension fund liability.
Shareholder Equity
The shareholder equity section of a balance sheet includes what is known as retained earnings, which are the net earnings a company uses to reinvest in the business or to pay off debt. What remains after that is distributed to shareholders as dividends.
Stock is also a common category under the equity section of a balance sheet, and it, too, can be broken down into different categories. Common stock can be bought and sold on the stock market, allowing individuals to secure partial ownership in an organization. Some companies also issue preferred stock, which provides different rights as common stock and will also be issued separately.
Determining Your Working Capital
The essence of the balance sheet is highlighting the working capital of a company, evaluating if an organization has enough liquid assets to cover debts coming due in the next twelve months. If there is significant working capital, a company will likely be able to meet all near-term obligations while providing funding for investments in the business or possibly returning funds to owners. If working capital is negative, it means the company owes more than it can pay over the next 12 months. The organization will need to seek other financing sources, or its viability may be at risk.
A balance sheet makes determining working capital simple. It allows you to visualize assets and liabilities, subtract the latter from the former, and deliver the information you need.
Balance Sheets & Long-term Planning
While balance sheets provide a snapshot view of your current financial status, compiling and reviewing them on a monthly basis allows you to take a long-term view of your organization’s financial health and stability. That’s why including non-current assets and liabilities is critical: It allows you to mitigate risk and plan for the future.
How? Consider this: Reviewing your current and non-current assets allows you to determine the overall liquidity of your organization, helping you understand if you can meet your most pressing financial obligations. Surveying your current and long-term liabilities allows you to see what is coming due shortly and what costs you need to plan for over the coming years.
As business owners, it is easy to fall into the trap of thinking only of what’s happening right now – what fires are burning, what opportunities are popping, what problems need solving. But long-term vision and strategic planning are just as important, allowing you to plan and prepare for the future.
How a Fractional CFO can help
Accounting and bookkeeping professionals are highly skilled at producing balance sheets. But for many business owners, the question is not about what you need to know, but what you can do with the information you have. That’s where a Fractional Chief Financial Officer (CFO) can provide invaluable support. CFOs take the financial information you have and use it to produce a financial roadmap for your organization – one that anticipates problem areas and creates the capacity to seize opportunities as they arise.
