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:
- How a balance sheet works
- How to read the sections of a balance sheet
- Practical applications of the balance sheet
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.
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.
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).
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.
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.
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.
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 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.