Heard of a balance sheet, but not sure what it is or what it does? I’m here to demystify this important financial statement and help you understand how it can help you interpret your business’ finances.
What is a balance sheet?
A balance sheet provides a snapshot of your company’s financial position at a specific point in time. It lists all your assets, liabilities, and shareholders’ equity, showing what you own and owe, and the net worth (equity) at that moment.
What purpose does it serve within your business?
Your balance sheet is essential for assessing your financial health and evaluating liquidity – and when it’s used correctly, it can help you make much smarter financial decisions that could affect your company’s future stability and potential for growth.
Investors and lenders will often ask to see your balance sheet if you’re planning to make a new investment or extend your credit terms, because it contains everything they need to assess whether you’re in a solid financial position (or not).
How to analyse your balance sheet
A balance sheet is structured into three main sections:
1. Your assets
These are the resources that are owned by your company, divided into:
- Current assets: Cash, accounts receivable, inventory, and other assets that can be expected to be converted to cash within a year.
- Non-current (fixed) assets: Long-term assets like property and equipment, and intangible assets like patents.
2. Your liabilities
These are the debts or obligations owed by your business, divided into:
- Current liabilities: The obligations due within a year, such as accounts payable, short-term loans, and accrued expenses.
- Non-current (long-term) liabilities: Debt and obligations due beyond a year, like long-term loans and bonds.
3. Shareholders' equity
This represents the owners’ claims after any liabilities are settled, and typically includes:
- Paid-in capital: The initial investments made by your shareholders.
- Retained earnings: The profits that have been reinvested in the business over time.
What financial insights can you get from your balance sheet?
There are several different ratios and other metrics that can help you extract useful information from your balance sheet. They may look a little complicated at first glance, but bear with me!
When you’re running a business, you need to know, at a basic level, what you’ve got and what you haven’t got – and how much you can afford to get. Liquidity ratios indicate your company’s ability to meet its short-term obligations. The two most common ratios include:
- Current ratio: You calculate this by dividing your current assets by your current liabilities. If your ratio is above 1, this means there are sufficient assets in the business to cover your liabilities.
- Quick ratio: This is represented by the formula (current assets – inventory) ÷ current liabilities. By removing your inventory from the equation, you can see if your business is able to meet its short-term debts with the assets that are readily available, right now.
Leverage ratios enable you to assess your debt levels relative to your equity, giving insight into your financial risk. The debt-to-equity ratio is a particularly handy one. You can work this out by diving your total liabilities by shareholders’ equity. A higher ratio suggests your business is more reliant on debt, which may imply higher risk.
Finally, calculating your asset management efficiency will help you work out how effectively your assets are generating revenue. Here are a couple to try:
- Return on assets (ROA): This is your net income divided by your total assets. It measures your profitability relative to your assets, and shows you how efficiently your assets generate profit.
- Inventory turnover: This is your cost of goods sold divided by your average inventory. This ratio reveals how efficiently inventory is managed and sold – essential data if you regularly hold onto goods and materials.
Still confused by your balance sheet? I can help you decipher what’s going on in your business from a financial standpoint, using all the documents and information I have available to me.
Get in contact if you feel you need further supporting with managing your company’s books. You can also learn more about my bookkeeping and accounting services here.
