How To Read Your Balance Sheet
Imagine you’re building the home of your dreams. Expensive, time consuming, and intricate. It’s a project that has taken you years to develop and you’re just now preparing for a big push towards the next stage. However, you come to realize that amidst all of the chaos, your team forgot to lay the foundation and the home that has weighed on you mentally, physically, and financially for years appears to be completely unstable. Your home is in need of serious work. Now swap home for business and foundation for balance sheet. The dots have been connected.
This article will walk through all you need to know about balance sheets to run your business better. We’ll cover balance sheet basics, touch on reading and understanding the info, and offer a look into the application of insights gathered.
The Balance Sheet Basics
Your balance sheet offers a snapshot into the health and status of your business at any given period in time. This will consist of three key elements:
- Assets will encompass all that your company owns. To give you an idea of what this category includes, think of the cash in your accounts and fixed assets like property and equipment.
- Liabilities include all the items that your company owes. Consider credit debts, vendor bills, recurring payments, and tax obligations as a few potentials.
- Equity will be the difference between your assets and liabilities. Pretend that your company sells all of its assets and pays off all of its debts - this is what you have left.
With those three dialled in, we can now take a look at balance sheet examples and explore the vivid picture it tells about the health and status of your business.
How It Works
Your assets, liabilities, and equities will be laid out on the balance sheet in detail, diving deep into your total assets, liabilities, and equity. This is important as it explains how sheet navigation should be approached. Each portion will have a total with detailed breakdown outlining the individual components leading to that total. For example, here’s what a standard balance sheet assets section will look like:
You’ll begin to notice that subcategories you’re unfamiliar with exist under each section. The assets page, as an example, includes the likes of current, fixed, other, and so on. These categories are purely for organizational purposes, and act as a way of binning together items with similar attributes. Here’s a quick run through of what a few of the key sections you’ll see mean:
- Current Assets are what your business expects to convert into cash within one year. When you think ‘current’ you should think of items like inventory and cash.
- Fixed Assets are what your business uses to operate, including equipment, vehicles, and property. Since fixed assets will generally lose value over time, the balance sheet factors in the depreciation expense.
- Other Assets are a touch less obvious than the other two. They include assets required to run your business that don’t necessarily generate income. For example, the cost of incorporation or a cash deposit on inventory.
Similar to assets, liabilities and equity come with their own set of sections and terms. Here’s an example of what your breakdown may look like, and a quick explanation for what the terminology used throughout means:
- Current Liabilities are debt obligations that your company needs to pay back within one year. They include bank loans, credit cards, and unpaid bills.
- Long-term Liabilities are debt obligations that need to be repaid back in… You guessed it, longer than one year. They include long term items like mortgages, and bonds.
- Shareholders’ Equity constitutes what is left over once all assets have been sold and the debts paid. It’s referred to as ‘shareholders equity’ or ‘stockholders equity’ because it’s typically what gets paid out to the owners of the business.
Remember that for the balance sheet to balance, assets must always equal liabilities and equity.
So now you know how to review the balance sheet and all of it’s sections, providing a detailed snapshot of health and status, but what does that really mean for you? Well, a few things...
First, it means that you’re now able to determine how well the business is doing by assessing industry-specific metrics. To get you started, here are a few key ones to keep in mind:
- Current Ratio (current assets/current liabilities) is what let’s you know whether or not you have enough cash to pay your short term bills. This metric is definitely an important one to keep in mind for growing your business.
- Debt-to-Equity Ratio (total debt/total shareholders’ equity) is what gives you an idea as to how dependent your business is on debt. This ratio will help you and your team with planning business growth.
You’ll also want to pay attention to items like liquidity (i.e. how much cash you have available) to ensure that you’re never at risk of missing bill payments, and working capital which will help you understand how your liabilities size up against your assets.
To get the most insights possible from your balance sheet, you’ll want to pair the information gathered with your cash flow and profit-loss (P&L) statements. Doing so will create a complete view of the business’s health and direction. Here are two examples of what we mean:
- Like your balance sheet, your profit and loss sheet dives into the money coming in and going out of the business. Unlike your balance sheet, your P&L isn’t of a singular snapshot in time. It shows you a trendline of your revenues and expenses over time, and it does a great job of putting your balance sheet into context. With it you’ll be able to compare how the balance sheet compares to other points in time over the course of a quarter, year, or decade.
- Your cash flow statement is the most accurate depiction of your cash status. Unlike your balance sheet and P&L statement, it only looks at money that has physically come into or gone out of the business (not money that is expected to). Comparing it with the other two sheets will allow you to assess your collection performance and determine if your expected revenues and expenses over time are consistent with your actual revenues and expenses.
With that, you should now be feeling confident about your balance sheet basics. Take some time and review company sheets from quarters and years past. This will help you apply what you’ve learned and ensure that you’re ready to better understand the health of your business and plan for the future.
Thanks for reading!