The balance sheet: one of the three main financial statements
Incorporated businesses must include income statements, cash flow statements and balance sheets in their financial reports. They can use these to report to tax and regulatory authorities and shareholders. Small businesses can use balance sheets to get a snapshot of their position and compare their financial situation over time.
Before getting into the balance sheet, here are short definitions of the other key financial statements:
- Income Statement: This report shows how much income a company has made during a particular month, quarter or a year. You can obtain net income for a specific period by deducting total expenses from total revenue.
- Cash Flow Statement: The statement of cash flows shows how the cash or cash equivalents are moving in and out of business. You will know that a company is not doing well when you observe chronic negative cash flow.
The balance sheet
In simple words, a balance sheet is a statement of a company’s financial position. You create this document by calculating total owner’s equity, assets and liabilities at a given point. Checking a company balance sheet will show you the net worth of a firm.
Sometimes businesses will show details of balance sheets from previous years. You can use records from earlier years to understand or to compare how the business has been doing. This information can help a company improve its finances.
The balance sheet also helps businesses plan well on how to use money that they get to meet their financial obligations. Though it’s not mandatory for sole traders and partnerships to prepare balance sheets, it’s wise to keep them to better evaluate how well the business is doing.
It helps business owners and managers in decision making, such as choosing between a new loan or equity finance. If a company is planning to sell its property, it should know its net worth first. Balance sheets are also used by business lenders to determine if and how much they will lend to a business. When seeking a traditional term loan from a bank, they will want to see accountant-certified financial statements including a balance sheet.
You usually categorise all accounts in a general ledger under assets, liabilities or equity. To understand the relationship between these three things, you will need to understand the following accounting equation:
Assets = Liabilities + Owner’s Equity
The components that you find on the balance sheet are not the same for all businesses. They vary depending on the industry. But you can divide all components under one of the following three segments summarised below.
In the assets section, accounts are listed from top to bottom in the order of liquidity. In other words, the ease of converting the asset into cash. There are two types of assets – current and non-concurrent assets.
Current assets are items that you can convert into cash in less than a year. On the other hand, non-current assets are long-term assets that you cannot easily convert into money in a short period.
Here’s the typical order of accounts under current assets:
- Hard cash or cash equivalents: These are mostly liquid assets. You will also include things such as treasury bonds and notes in it, as well as deposit certificates that are short term. You also include cash if you have it on hand.
- Marketable securities: These are debt or equity securities that can be quickly sold in the market.
- Accounts receivable: This mainly refers to the amount that customers owe a business. It’s wise to include an allowance for bad debt, as some customers will never pay what they owe.
- Inventory: These are goods that you are planning to sell. Businesses value these goods as per the market price or little less than its actual cost.
- Prepaid expenses: This is the value of what you have already used to pay for things such as rent and insurance. Advertising contracts, for example, fall under this category.
Long-term assets include:
- Long-term investments: These are securities that you cannot liquidate by the end of the following year.
- Fixed assets: These include capital-intensive assets such as land, machinery, building, equipment and other items that are durable.
- Intangible assets: Assets that are non-physical or intangible but can be valued, such as goodwill and intellectual property, fall under this category.
The money a business owes to an outside party is called a liability. It might be an amount that the company has to pay to a supplier or the interest it has to pay towards bonds that they issued to creditors. Salaries, utility costs, and rent also fall under this category.
If the amount is due within one year, it’s called a current liability. Depending on the due date, you list it accordingly in the balance sheet. Any amount that you owe after a year is called long-term liability.
Accounts that fall under current liabilities include:
- Money owed to banks
- Current portion of a long-term debt
- Utility, tax, and rent
- Salaries payable
- Interest payable
- Dividends payable
- Customer prepayments.
Long-term liabilities include:
- Long term debt: This is the interest and principal you owe on bonds.
- Deferred tax liability: Accrued taxes that you cannot pay until the next financial year.
In a nutshell, owner’s equity is the money that you can attribute to business owners or shareholders. It’s also known as ‘net assets.’ For small business owners, you would use the term ‘owner’s equity’ instead of ‘shareholder’s equity’. You can find the amount once you deduct the liabilities from assets.
The net earnings that a business decides to reinvest or pay off the debt is called retained earnings. The remaining amount can be distributed to shareholders as dividends.
If a company never sells a portion of its stock initially or repurchases it later, it’s called treasury stock. A business can choose to sell it later to raise money or to withstand a hostile takeover. Few firms also issue preferred stock, and they do not list them with common stock.
Just like common stock, they also assign it an arbitrary par value. You can calculate common stock as well as the preferred stock by calculating par value with the total number of the shares that are issued.
Putting together your balance sheet
Understanding these concepts is crucial for preparing a balance sheet. Here’s a sample balance sheet to give you a clear idea of what’s included.
Most accounting software programs make it easy to create a balance sheet. For important financial decisions and disclosure requirements, get advice from an accounting professional.
If you are creating a balance sheet as a step for getting a business loan, learn more in The Complete Guide to Business Loans in Australia.