How to Read a Balance Sheet: Your Quick Guide

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8
min read
October 20, 2021

There comes a time when every business must step back and evaluate its worth.

Budgeting your current finances is crucial for that — not only for you but also for any potential investors. A balance sheet can make managing your budget a whole lot easier, regardless of whether you’re a small or large business. 

In this guide, you’ll learn:

What Is a Balance Sheet?

A balance sheet, also referred to as a “statement of financial position” details your company’s assets, liabilities, and owners’ equity. 

You can use a balance sheet to get an understanding of your company’s current financial position. In other words, it paints a high-level picture of your financial health at a single point in time, as opposed to over a period of time.

The balance sheet, income statement (how your company performed over a period of time), and cash flow statement (amount of cash and cash equivalents coming into and leaving the company) make up your business’s primary financial statements. 

What’s Included in a Balance Sheet

Balance sheets are broken down into two parts (assets and liabilities) based on the balance sheet formula outlined below. The two sides of the equation must equal one another, hence the name “balance” sheet.

Assets = Liabilities + Shareholders’ Equity

In other words, the assets used to operate your business should be balanced out by liabilities (such as loans and supplier payments) and equity from shareholders.

If the two sides of your balance sheet do not equal one another, it means there’s been an accounting error such as forgetting to record cash transactions or forgetting to update inventory levels.

For example, if your business takes out an $8,000 loan from a bank, your assets will go up by $8,000. Meanwhile your liabilities (i.e. your long-term debt) will also go up by $8,000, thus balancing the two sides of the equation. Let’s say you take another $10,000 from investors, then your assets will increase by $10,000 and so too will you shareholder equity. The equation is, once again, balanced.

Assets

The left side of your balance sheet lists all of your company’s assets, which refers to anything of value that your business controls or uses to operate. On a vertically oriented balance sheet, assets appear at the top.

This section includes your current (or short-term) assets and your non-current (or long-term) assets, which you then add up to calculate your total assets.

Liabilities

The right side of your balance sheet lists your total liabilities, or any money owed to third parties such as suppliers or lenders. If your balance sheet is arranged vertically, you’ll see this section underneath assets.

Like your assets, liabilities can also be divided into two categories: current (short-term) and non-current (long-term). 

Equity

Below your total liabilities, you’ll find equity, which may be listed as shareholders’ equity, owners’ equity, or stockholders’ equity. This value represents the money left over for the owner (or shareholders) after you subtract liabilities from assets.

Two main sources of owners’ equity are the money initially invested into the business (often in the form of stock) and any profits that are reinvested into the business (retained earnings).

Calculating Assets, Liabilities, and Equity

Now we’ll look more in-depth at each element of the balance sheet equation and how to properly calculate and categorize each section. 

Calculating Assets

Your assets include all of the resources your company possesses (or controls) and uses to operate. Think of your office building, office equipment, and inventory as examples of assets

It’s important to note that your company does not have to own all of its assets. For example, if you take out a loan to pay for a new piece of equipment, technically the bank owns the equipment, but your company possesses it.

Many companies separate assets into three main sections: current, fixed, and intangible. Current assets refer to your short-term assets, while fixed and intangible assets are two types of long-term or non-current assets.


Let’s take a closer look at what each category includes.

Current assets include all assets that can be converted into cash within one year, such as inventory, accounts receivable, cash, and cash equivalents.

Fixed assets, also called capital assets, include all tangible long-term assets. Tangible assets refer to physical assets, such as buildings or office supplies. Long-term means you won’t be liquidating your physical assets (selling them for cash) within the next year. 

You may also see fixed assets listed as “Property, Plant, and Equipment” (or PP&E) on the balance sheet. 


Accounting for the book value is helpful, meaning the value of all your assets, just without anything intangible or any liabilities. From this, you can see the worth of your company on the ground floor.


Intangible assets
refer to non-physical assets that still create value for your company. For example, if you have a 20-year patent on your products, that’s an intangible asset that gives you a competitive advantage. Other examples of intangible assets include long-term investments like brand recognition, trademarks, copyrights, and the company’s intellectual property.

It’s important to realize that not all intangible assets appear on the balance sheet. Accounting standards dictate that you cannot list internally generated intangible assets on the balance sheet. 

Rather, an intangible asset only appears on the balance sheet if it’s been acquired. So, patents that you develop internally do not appear on the balance sheet, but a patent that you purchase from another company can be listed as an intangible asset.

The General Accepted Accounting Principles (GAAP) include acquired intangible assets on the balance sheet because they have an identifiable value that was determined in the purchase of the company or the asset. In other words, you can’t list internal intangibles, because you don’t know their value until you sell the asset or use it to calculate the market value of a company.

If you have intangible assets, you can use the practice of amortization, which spreads the cost of those assets over their useful life. Usually, the same amount is expensed every period and listed on the balance sheet.

Calculating Liabilities

The liabilities section of the balance sheet involves money owed to third parties, with both short- and long-term debts. 

Liabilities get subdivided into two categories (current and non-current), both of which appear on the balance sheet.

Current liabilities, or short-term liabilities, include financial obligations you must pay within one year, such as accounts payable, short-term loans, prepaid expenses, and interest payments due for long-term loans.

Non-current liabilities, also known as long-term liabilities, refer to financial obligations that are due after one year from the date on your balance sheet. This section includes items such as car payments or loan payments due after the current year.

Calculating Owners’ Equity

The final portion of the balance sheet includes money attributable to the owners, whether that’s a single owner or a group of shareholders. This section reflects the initial monetary investment in the business as well as any profits reinvested back into it.

Using the balance sheet equation, you can calculate equity as total assets minus total liabilities. In other words, if a business owner sells all assets and then pays off all financial obligations, the remaining amount reflects the owners’ equity.

There are several types of accounts that contribute to owners’ equity. Here are the most common.

Common Stock 

The common stock account represents the monetary investment that the owner (or stockholders) made in the business. Common stock is calculated as the value of a single common share (also known as the stock’s par value) multiplied by the number of shares outstanding. 

Additional Paid-In Capital

Additional paid-in capital refers to any money that shareholders pay above the common stock value. This account typically reflects the amount of money shareholders pay when buying stock directly from a business as opposed to purchasing stock on the stock market.

Retained Earnings

Retained earnings means money set aside for reinvesting after the current earnings are known. The business retains these funds to manage liabilities and debts incurred or reinvests them into the company.

Putting it Together: Balance Sheet for a Small Business

Now that you’re familiar with the three parts of the balance sheet equation, let’s look at an example of a balance sheet for a small construction business. In this example, the balance sheet is organized vertically, with assets on top followed by liabilities and then equity.

Sample Balance Sheet
Line Item Total Value
Current Assets
Inventory
Marketable Securities and Cash
Project Backlog
$100,000
$400,000
$300,000
Total Current Assets $800,000
Fixed Assets
Machinery
Offices and Land
Equipment
$2,600,000
$1,200,000
$800,000
Total Fixed Assets $4,600,000
Total Assets $5,400,000
Current and Long-Term Liabilities
Accounts Payable
Accrued Expenses
Mortgage (long-term)
$600,000
$400,000
$2,100,000
Total Liabilities $3,100,000
Owners’ Equity $2,300,000
Total Stockholders’ Equity and Liabilities $5,400,000


From this, we can see the sheet listing everything owned, starting with current assets, followed by fixed assets.

In the case of the construction company, they’ve accounted for several assets:

  • Inventory includes itemized building materials.
  • Marketable Securities and Cash involve bonds you can instantly cash in, which are short-term liquid assets.
  • Project Backlog includes all the projects the company has bid on, meaning they’re sellable.
  • Machinery is a fixed asset, and in construction will involve cranes and mixers, meaning a lifespan of several years.
  • Office and Land is another fixed asset, as it’s land outright owned by the company.
  • Equipment is similar to machinery, including furniture and office accessories.


Next is liabilities, with both current and long-term added in:

  • Accounts Payable is money owed to the suppliers that provide the company with goods and services.
  • Accrued Expenses are expenses that haven’t been paid for yet but are nonetheless recorded in the books when they’re incurred.
  • Mortgage means paying off the property.


Beneath that, we have owners’ equity, which goes to the business owners, and everyone invested in the company. Owners’ equity is listed here as a single line, which is common for small businesses that don’t issue stock or have shareholders.

Finally, we can verify that the values in each section are correct by inserting them into the balance sheet equation. 


Assets = Liabilities + Equity

5,400,000 = 3,100,000 + 2,300,000

5,400,000 = 5,400,000 


Both sides of the accounting equation are equal, so the values on this balance sheet check out.

Comparing Multiple Years on One Balance Sheet

Remember, a balance sheet details your financial health for a single point in time (a single date). A balance sheet usually takes up no more than a page. In addition to assets, liabilities, and equity, the balance sheet also lists the date that the values were recorded. 

If you want to compare your financial health from year to year, you can add a column to your balance sheet for each year. 

Alternatively, you can compare your financial health each quarter by using a column for the last date of each quarter and then look for trends. 

Why Use a Balance Sheet?

Now that you can read a balance sheet, you might be wondering, “Why is this important?” There are several reasons for reviewing and analyzing a balance sheet, both internally and externally. 

Your balance sheet can give you quick insight into the current financial strength of your business. Over time, you can compare your quarterly and annual performance to see if your business strategies are working or need improvement. Employees and department leaders may also review the balance sheet to see if they’re on track to meet your business’s goals. 

Externally, investors read balance sheets when deciding whether or not to invest in a company. And finally, auditors may review balance sheets to ensure your business is complying with General Accepted Accounting Practices.

Your balance sheet is also a quick reference document you can use when calculating financial ratios such as the current ratio, quick ratio, or debt-to-equity ratio. Using your balance sheet, financial statements, and financial ratios together gives you a comprehensive idea of your company’s financial position. 

So, whether you want to sell your business or just see how it’s doing, knowing how to read a balance sheet is an essential accounting skill for small business owners. 

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