The balance sheet came into being all the way back in the 15th century when Italian monk Luca Pacioli gave the standard accounting system an overhaul.
Now, balance sheets are an accepted and required financial statement.
If you are a business owner or founder it is essential that you understand and know how to read a balance sheet. Balance sheets give you invaluable insights into your operation and can provide a snapshot of its financial position.
If you do not know how to read your company’s balance sheets, you will be in the dark as to the assets, liabilities, total equity, and standing of the business. This will, in turn, hinder your financial decision making.
Informed decision making can be the make or break of a business, therefore—if you are unsure of what your balance sheet is saying, read on. We are about to break down the purpose of a balance, the things it can tell you, as well as couple things it can’t.
What Is a Balance Sheet?
A balance sheet is one of the main financial statements besides the income statement, cash flow statements, and statements of shareholder equity.
The balance sheet is unique in that it shows a business’s resources separate from any claim on them.
It this sounds confusing, don’t sweat.
A balance sheet does this by listing all of the assets and liabilities of a business. In other words, it shows the total value of everything the business owns, such as properties, equipment, and debtor accounts. It also shows the total value of everything the business owes, such as bank loans, mortgages, creditor accounts and outstanding bills, accrued expenses, and overdrafts.
By putting these two totals together, a business owner can quickly see whether a business’s debts outstrip its assets or vice versa.
However, this is just one of the things a balance sheet can tell you. There are a few other key insights it can give you, which we’ll get into after taking a look at how to go about reading a balance sheet.
How to Read a Balance Sheet
Although at first glance a balance sheet can look complicated, they are actually pretty simple once you know how to read one.
If you pick up your business’s balance sheet, you will see that there are two columns. One has the names of the accounts/categories of your business’s assets and of its liabilities. The assets and liabilities will be clearly split, with the assets coming first.
The other column shows the total amounts for each category of the assets and liabilities.
At the bottom of these columns is a collective total of these categories. Under assets, you will see a figure that shows the total value of assets of the business, and the same for liabilities.
Right at the bottom of the balance sheet, there will be a final total termed ‘shareholder’s equity’. This shows the value that is left after the business’s liabilities have been deducted from its assets.
Key Things a Balance Sheet Can Show You
Besides giving you a snapshot of your business’s total assets and liabilities and of its equity, a balance sheet can also tell you a few other important things.
It is important to know about these, and how to spot this data, because these insights can help you maintain the financial health of your business.
1. Liquidity
A very useful thing your balance sheet can tell you is the state of liquidity within your business.
Some of the main types of assets listed on your balance sheet include liquid assets such as the money in your business’s bank account, cash, and any debtor accounts. This money is liquid and can be used immediately.
At the same time, your balance sheet will probably also show some illiquid assets, such as properties and equipment.
The balance between these two categories of assets will show you how liquid your business assets are.
2. Capital Structure
A balance sheet can give you a very clear picture of the capital structure within your business. Capital structure is the way in which capital (what you put into your business) is distributed within a business.
Balance sheets show this by listing how much money is locked into assets, the nature of these assets, and the amount and type of liabilities that are offset by these.
By analyzing the capital structure of your business you can make key decisions regarding how capital is distributed in the future.
For example, if your balance sheet is debt-heavy, it may be worth slowly transferring liquid assets towards these liabilities in order to reduce them.
What a Balance Sheet Can’t Tell You
While balance sheets can reveal a lot about your business, there are also a few things that balance sheets do not always show.
These include intangible assets, such as business reputation, brand names, patents, trademarks, licenses, economic goodwill, company culture, and employee productivity.
Intangible assets are sometimes represented on balance sheets, however, these values are estimates at best and should be taken with pinch of salt.
How to Use Your Balance Sheet for Better Decision-Making
Balance sheets can be used to assist in a number of decision-making areas. These include the following.
Budgets
Sound budgeting decisions are key to the success of any business. You can use your business’s balance sheets to analyze potential budget changes. Once again, the relationship between your business’s assets and its liabilities will indicate whether or not it is prudent to go big with a large budget, or whether the business needs to do whatever it can to make a reduced budget work.
If you would like to learn more about creating budgets for your business, check out this post.
Liquidation
As your balance sheet lists all of your assets and liabilities, you can use it when deciding what assets to liquidate. If your balance sheet is showing a lot of non-asset building debt, such as long term loans and credit card debt, you may want to analyze the assets section to ascertain which assets might be liquidated to remove some of the debt.
If you are planning to purchase an asset, you can also use the balance sheet data to figure out whether you should take out a loan for this, or liquidate one of your existing assets.
Investment
If you and your business are considering investing in another business, you can use the company’s balance sheet to ascertain the financial viability of the decision.
A company that has a high debt to asset ratio will not be nearly as sure an investment as one which shows a healthy asset to debt relationship and good liquidity.
Do You Need Help With Your Financial Statements?
Balance sheets are a crucial tool in a business owner’s decision-making arsenal.
However, not only do you need to be able to read a balance sheet effectively, the balance sheet itself needs to be drawn up based on sound accounting.
This is where we come in. We offer both full accounting services and statement preparation services. What’s more, if your business has reached the stage where its financial statements need to be analyzed by a pro, we also provide outsourced CFO services.