Business financial statements consist of three main components: the income statement, statement of cash flows, and balance sheet. The balance sheet is often the most misunderstood of these components—but also most beneficial if you understand how to use it.
The balance sheet provides a snapshot of the overall financial condition of your company right now. It lists all of the company’s assets, liabilities and owner’s equity in one simple document. By subtracting liabilities from assets, you can determine your company’s net worth at any given point in time.
Check out our free downloadable Balance Sheet Template for more, and keep reading to learn the different elements of a balance sheet, and why they matter.
Components of a balance sheet
Typically, a balance sheet is divided into three main parts:
1. Assets
Current assets are those that can be converted to cash within one year. They typically include cash, stocks, accounts receivable, prepaid expenses, and inventory.
Fixed assets are tangible assets that are for long-term use, such as equipment, machinery, vehicles, land and buildings, furniture and fixtures, and leasehold improvements. Many other assets don’t fit within either of these categories so most balance sheets include an “other assets” category for these items—typically things like long-term investment property, life insurance cash value, and compensation due from employees.
2. Liabilities
Current liabilities are business obligations due within one year.
These typically include short-term notes payable (including lines of credit), current maturities of long-term debt, accounts payable, accrued payroll and other expenses, and taxes payable.
Long-term liabilities are business obligations that are due outside of one year, such as any bank debt or shareholder loans with maturities longer than one year.
3. Owner’s equity
This is the sum of all shareholder money invested in the business and accumulated business profits. Owner’s equity includes common stock, retained earnings, and paid-in-capital.
How to use the balance sheet
Your balance sheet can provide a wealth of useful information to help improve financial management. For example, you can determine your company’s net worth by subtracting your balance sheet liabilities from your assets, as noted above.
Perhaps the most useful aspect of your balance sheet is its ability to alert you to upcoming cash flow shortages. After a highly profitable month or quarter, for example, business owners sometimes get lulled into a sense of financial complacency if they don’t consider the impact of upcoming expenses on their cash flow.
There are two easy-to-figure ratios that can be computed from the balance sheet to help determine whether your company will have sufficient cash flow to meet current financial obligations:
Current ratio
This measures liquidity to show whether your company has enough current (i.e., liquid) assets on hand to pay bills on-time and run operations effectively. It is expressed as the number of times current assets exceed current liabilities.
The higher the current ratio, the better. A current ratio of 2:1 is generally considered acceptable for inventory-carrying businesses, although industry standards can vary widely. The acceptable current ratio for a retail business, for example, is different from that of a manufacturer.
The formula:
Current Assets / Current Liabilities
Quick ratio
This ratio is similar to the current ratio but excludes inventory. A quick ratio of 1.5:1 is generally desirable for non-inventory-carrying businesses, but—just as with current ratios—desirable quick ratios differ from industry to industry.
The formula:
Current Assets – Inventory / Current Liabilities
Knowing your industry’s standards is an important part of evaluating your business’s balance sheet effectively, which is one reason why we offer free sample industry reports to small businesses. Using the balance sheet included in your industry’s report, you can calculate the current ratio and quick ratio that are desirable for your business type, to get a better sense of how your own business’s ratios stack up.
Get familiar with your balance sheet
Most companies should update their balance once per quarter, or whenever lenders ask for an updated balance sheet. Today’s accounting software programs will create your balance sheet for you, but it’s up to you to enter accurate information into the program to generate useful data to work from.
The balance sheet can be an extremely useful financial tool for businesses that understand how to use it properly. If you’re not as familiar with your balance sheet as you’d like to be, now might be a good time to learn more about the workings of your balance sheet and how it can help improve financial management.
Create your balance sheet easily by downloading our Balance Sheet Template, and check out our article on The Key Elements of the Financial Plan for more info on your business financials.
Trevor is the CFO of Palo Alto Software, where he is responsible for leading the company’s accounting and finance efforts.
