There are few financial statements more important than balance sheets. This document contains details of a company's assets, liabilities, and equity. In a nutshell, it provides a snapshot of the company’s finances and is used to evaluate its performance. When paired with cash flow statements and income statements, balance sheets help provide a full picture of a company’s finances for a specific point in time.
Let’s take a look at everything you need to know about balance sheets.
Why is a balance sheet important?
A balance sheet details what a company owes and owns during a specific time period. When reviewed internally by the business owner, employee, or accountant, it’s intended to highlight the extent to which a business is succeeding in terms of revenue. This data helps inform changes in policies or approaches moving forward.
When reviewed externally by outside parties such as potential investors, a balance sheet is designed to outline how the company was financed and what resources they may or may not have. It enables potential investors to determine a business’s financial health and to use this information when deciding whether or not to invest.
What does a balance sheet consist of?
A balance sheet consists of three main components assets, liabilities, and shareholder’s equity. Let’s take a look at what exactly this means.
In simple terms, assets are anything a company owns that can be converted into cash. Assets can be split into two categories: current and fixed. Current assets are what a company expects to convert into cash within a year’s time. This includes cash and cash equivalents like treasury bills, accounts receivable, and inventory. Fixed assets are purchased for long-term use and include property, equipment, and long-term investments.
Liabilities are the opposite of assets–they are what a company owes others. This includes debts or other financial obligations. Liabilities are categorized as current (due within a year) and long-term (due date is more than a year away). Current liabilities include accounts payable, employee wages, taxes owed, and loans that need to be paid back within a year. Long-term liabilities include loans that you don’t have to pay back within a year and bonds your company has issued.
Shareholder’s equity is the amount of money paid by shareholders in exchange for shares in the business. It’s also the amount of money generated by a business. This includes stock, shared capital (the amount of money a company receives from its shareholders), and retained earnings (the total amount of net income a company decides to keep).
The balance sheet equation
Information on a balance sheet will almost always be calculated based off the following equation: Assets = liabilities + owner’s equity
This formula is relatively straightforward. That’s because companies have to pay for everything they own (assets) by either borrowing money (liabilities) or by getting money from investors (shareholder’s equity).
Assets should always equal the liabilities and shareholder’s equity. In other words, they should always balance out (hence the name—balance sheet). If they don’t balance out, there is likely incorrect data or miscalculations that took place.
If a company takes out a $10,000 loan from the bank to cover the cost of a store renovation, its assets will increase by $10,000. Its liabilities will also increase by $10,000, balancing out the equation. And if the company takes $5,000 from investors, its assets will also increase by that amount.
How to create a balance sheet
1. Select the reporting date
A balance sheet depicts total assets, liabilities, and equity of a company on a specific date. That’s why it’s important that you determine the exact period you’re reporting on. Most companies prepare their balance sheets on a quarterly basis.
2. Identify your assets
After you’ve selected your reporting date, you'll need to calculate your assets according to that date. It’s best to separate your assets into the two categories we covered–current and fixed. Current and fixed assets should both be subtotaled, and then ultimately added together.
3. Identify your liabilities
You’ll also need to record your liabilities. Organize your liabilities into current and long-term. Then, like above, subtotal each category and then add them together.
4. Calculate shareholders’ equity
You now should incorporate the share capital you get from investors and retained earnings.
5. Add and compare
To make sure your equation is balanced, you need to compare total assets against total liabilities plus equity, as seen in the equation above. If your liabilities + equity = assets, you’ve performed the equation correctly. If it doesn’t, you will have to go back and try to rework the formula.
Understanding the importance of balance sheets and knowing how to create them is essential to understanding the big picture of a business's financial operations. Creating a quarterly or year-end balance sheet will help you determine if you’re on track to meet your goals, will give you a thorough overview of your company’s performance, and will help you maximize your business’s financial health. Another way to maximize your financial health is by automating your bill pay. Sign up to Melio today to learn more.
*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.