The balance sheet is one of the most important financial statements because it shows a “snapshot” of a company’s financial standing. Sometimes referred to as the statement of financial position, it enables you to see what a business owns and what it owes. In a nutshell, the balance sheet breaks down a company’s assets, liabilities, and owner’s equity at a specific point in time - usually the end of a month or financial year. This helps you as a business owner determine the financial strength and ability of your business.
Getting to know the balance sheet
It’s called a balance sheet because assets must always equal liabilities plus owner's equity — the two sides balance out.
Assets are what the business owns. Liabilities are what the business owes now or in the future. The difference between both of these is the owner’s net worth (equity) of the business. This number can either be positive or negative – and if it’s negative, certain steps need to be taken to improve that number as soon as possible.
Ideally, you want the assets of the business to be greater than its liabilities, meaning the business owner’s equity will be positive. What you want to avoid is your company’s liabilities growing faster than its assets. So let’s review each of these sections one by one:
Assets
There are two primary types of assets: current and non-current. Current assets are items your business has acquired over time that will be used up or converted into cash within one year, or one business cycle, of the date on the balance sheet. Prepaid insurance, accounts receivables, temporary investments, cash, inventories, and liabilities are considered current assets.
Non-current assets are any fixed assets or items your business owns. Things that fall into this category are office equipment, building property, land, long-term investments, stocks, and bonds.
Liabilities
Liabilities are sort of like IOUs — together, they represent the total cash value of what the company owes to other entities. This includes amounts owed on loans, accounts payable, wages, taxes and other debts. Liabilities aren’t necessarily a bad thing. After all, companies have to spend money to make money. They only become a problem when a company is consistently spending more than it’s earning and has no clear and viable strategy to reduce that trend.
Owner's Equity
Owners' equity (sometimes called net assets or net worth) represents the assets that remain after deducting what you owe. In simplified terms, it is the money you would have left over if you sold your practice and all of its assets and paid off everything you owe. Note: Valuing a practice can be extremely complex. Owners' equity does not necessarily represent current market value and therefore should not replace a comprehensive valuation by an expert when considering buying or selling an existing practice.
Now what?
Now that you have a better understanding of the what a balance sheet is made up of, you can start to analyze the data. The most common technique for analyzing balance sheet data is by way of a financial ratio analysis.
A financial ratio analysis is a quantitative analysis of information contained in a company's financial statements. Financial ratio analysis is used to evaluate various aspects of a company's operating and financial performance such as its efficiency, liquidity, profitability and solvency.
The main types of financial ratios that use information from the balance sheet are financial strength ratios and activity ratios. Financial strength ratios, such as the working-capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how the obligations are leveraged.
Reviewing these ratios can give owners and investors an idea of how financially stable the company is and how the company finances itself. Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables). These ratios can provide insight into the company's operational efficiency.
Know what your company is worth by getting to know your balance sheet.