A company's balance sheet is its cornerstone financial report, as it shows how resources are acquired for operations and expansion. The key to understanding a balance sheet is knowing what it contains, where it comes from and why you need to know this information.
Balance Sheets
Balance sheets are one of the most essential documents a business owner must learn to read and interpret, as they detail how resources needed for operating are acquired - either through debt or equity financing arrangements.
As with the profit and loss statement, a balance sheet presents an overview of your company at any one point in time. The first section identifies which assets your entity owns (known as assets) as well as who holds their ownership - either another person (liabilities) or you yourself as owners of equity in the form of equity shares.
Assets are divided into current assets - those which can be converted to cash within one year - and noncurrent assets which are more permanent - with current liabilities being required to be paid within that year - as well as noncurrent liabilities being more long-term in nature. All of this data is then added together along with shareholders' equity figures representing retained earnings, contributions from investors and other sources of funds, giving an indication of net worth at any given moment in time.
Assets
Assets encompass anything with monetary value, such as cash, inventory, property, and equipment. Assets also include marketable securities (investments), prepaid expenses and money owed from payers (accounts receivable). Patents are considered assets as well.
The most common current assets on a balance sheet are currency, cash and cash equivalents, and short-term investments. These are the most liquid assets, meaning they can be easily converted into cash if a company wants it.
Non-current assets include things that are not expected to become liquid within a year. Tangible property, for example, is not considered a current asset because it will not be readily available to use in the next year.
Types of Assets
The balance sheet lists both current, non-current and fixed assets on a company's books.
Current assets are those that a company expects to convert to cash in less than one year. Examples of current assets include cash and cash equivalents, non-restricted bank accounts, inventory, securities, and accounts receivable.
Noncurrent assets consist of tangible, long-lived assets like machinery and equipment with an expected lifespan greater than one year and intangible assets like trademarks and copyrights that are valued based on their cost less accumulated depreciation. These assets add to the value of the business and can contribute to revenue generation.
These assets help companies to run their daily operations. They are often depreciated in the accounting cycle, meaning that they lose value over time.
Fixed assets are resources that businesses use for longer periods and can be sold or exchanged for a future payment. These can include real estate, buildings and equipment, as well as prepaid expenses.
Liabilities
Your company's liabilities represent money owed to other parties. Liabilities typically decrease company values and equity over time; unlike an profit and loss statement which reports revenue and expenses over a given timeframe, balance sheets offer an instantaneous picture of financial health at any point in time.
Liabilities represent all of the money and property owed by your practice to other people or companies, such as debts, taxes or wages. Like assets, liabilities are divided into current and noncurrent categories: current includes any amounts due within one year while noncurrent includes anything due more than 12 months later. Tracking these items helps plan future spending as well as identify any possible threats in your horizon.
Liability Types
Liabilities for any business are its debts to third parties and can be divided into current or non-current categories. Current liabilities refer to debts that will come due within a year and require cash payments, such as accounts payable and accrued expenses like employee wages. Non-current liabilities refer to debts that will need to be settled over more than one year; examples may include mortgage payments, loans and tax liabilities with delayed due dates.
First of all, it's important to remember that the very layout of your balance sheet tells you something about the timeframe for which the liability is expected to be paid. The shortest-term liabilities are the ones that you'll find at the top of the list; these are known as current liabilities.
A company's current liabilities can be broken down into the following categories: short-term debt, accounts payable (money owed to suppliers), wages owed, income and sales taxes owed, pre-sold goods and services, and deferred income and sales taxes. Non-current liabilities therefore can include loans on motor vehicles, mortgage for business premises and loans from investors and financial institutions.
Equity
Equity is the amount of money or resources a business owns. This is calculated by subtracting liabilities from assets. You can find equity at the bottom of your balance sheet, after both assets and liabilities.
These earnings can include retained earnings, a part of your business's earned income that it sets aside for future use or to reinvest in your business. A high level of retained earnings is an important indicator that your company has a strong balance sheet and a good financial position.
Retained earnings are a great way to track your company's performance and potential for growth. They can also help you evaluate how well your company can generate income from sales and other sources.
Totalling these three sections yields your net value as shown on your balance sheet, which should be regularly updated. Doing this can help identify any areas of concern and can also be an invaluable tool in building investor confidence or convincing lenders to finance your venture. Plus, keeping an eye on your bottom-line remains key metric for investors and regulators.
Why is this information important?
As its name implies, a balance sheet demonstrates the financial health of a company at any one point in time. It enumerates assets, liabilities and equity--two sides must always balance out. Assets include concrete items with monetary value such as cash, inventory and property/equipment assets while liabilities include accounts payable debt and income tax liability obligations owed by the business; finally, equity displays initial investments made by owners plus any retained earnings.
Business owners and financial experts use this information to evaluate the company's risk and liquidity, comparing the non-current liabilities to cash flow. A business's liquidity can also be used when looking at financial ratios, including the debt ratio and interest coverage ratio. These metrics can help managers assess whether or not a company will be able to meet its financial commitments.
While a balance sheet is prepared as of the current date, it usually includes data from prior years to allow a comparison. This is done by calculating the percentage change from the previous period, which is a great way to understand how your practice is performing in terms of performance over time.
An understanding of your company's balance sheet is key to securing business financing and managing cash flow effectively and can provide insight into its strengths and weaknesses.
What can I use this information for?
This information will allow business owners to gain a thorough understanding of your business’s financial health. This means understanding how resources (assets) are acquired; debts and obligations (liabilities); revenue generated from its work (equity); and how equity grows over time.
Balance sheets contain numerous ratios that can help assess your business, such as liquidity ratios, solvency ratios and financial strength ratios, activity ratios focused on current accounts receivable, inventory and payables as well as liquidity analysis ratios.
Understanding and reading your business's balance sheet is critical for making sound decisions that will ensure its success. Alongside income statements and cash flow reports, your balance sheet provides a complete picture of its finances. An understanding of your company's balance sheet is key to securing business financing and managing cash flow effectively and can provide insight into its strengths and weaknesses.
We hope that this guide has given you an understanding of balance sheet language so you can more easily interpret your own company's balance sheets and gain more insight into how your business operates.
For further information please contact our office to arrange an appointment with one of our accountants here at Allomes Accounting and Auditing.