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Balance Sheet: Definition, Analysis and Creation Best Practices
By Colin Higginbotham, TD In-Store Small Business Lead
Monté Foster, TD SVP, Retail and Small Business Banking
Maintaining a detailed balance sheet is important to keeping track of accurate accounting—of your company's assets, liabilities and equity. It's one of the essential documents every small business should have, as it can provide a snapshot into your strengths and opportunities for improvement. Explore the article's main topics and content:
What is a balance sheet?
A balance sheet is a key financial statement that represents a company's financial status at any given point in time, capturing the company's assets, liabilities, and equity in a single document. When used together with the income statement, cash flow statement, and owner's equity statement, the balance sheet can help assess the overall financial health of a business.
Why should a business create a balance sheet?
As an essential tool in showcasing a company's or organization's short-term financial stability and standing, the balance sheet can be used to help:
- Determine a business's ability to pay debts or expenses
- Confirm current levels of cash on hand for attracting potential investors
How to create and structure a balance sheet
Balance sheets are usually created using this basic formula: Assets = Liabilities + Equity. The overall assets of a company (what it has or is owed) are "balanced" by the company's liabilities (what it owes) plus its equity.
A typical balance sheet will be structured in such a way as to capture the company's assets in the top section and the liabilities and equity in the bottom section, with assets and liabilities divided into both current and non-current.
Following is an example of a simple balance sheet and definition of terms.
Balance Sheet Statement
As of <insert date>
|
Assets |
|
|---|---|
|
Current assets |
|
|
Cash |
$65,000 |
|
Accounts receivable |
$25,000 |
|
Pre-paid inventory and expenses |
$20,000 |
|
Total current assets |
$110,00 |
|
Non-current assets |
|
|
Equipment |
$50,000 |
|
Total non-current assets |
$50,000 |
|
Total assets |
$160,000 |
|
Liabilities |
|
|---|---|
|
Current liabilities |
|
|
Accounts payable |
$10,000 |
|
Salaries payable |
$5,000 |
|
Taxes |
$15,000 |
|
Total current liabilities |
$30,000 |
|
Non-current liabilities |
|
|
Long-term bank loans |
$40,000 |
|
Total non-current liabilities |
$70,000 |
|
Equity |
|
|---|---|
|
Owner's equity |
$10,000 |
|
Retained earnings |
$80,000 |
|
Total equity |
$90,000 |
|
Total liabilities and equity |
$160,000 |
It's a good idea to indicate the date and time on the document. The number of line items under assets, liabilities and equity will vary based on the business and what is involved in its day-to-day operations. For example, retail companies may have inventory costs while service-based businesses may not.
Go to Microsoft Office to download a free balance sheet template.
The five elements of a balance sheet defined
1. Current assets
Current assets are assets that can be converted into cash-on-hand within one year. The most accessible form of this is cash from bank accounts and check deposits. Cash is common with current assets, and you would use cash at the end of the period from your statement of cash flows.
Accounts receivable and working inventory are other examples of current assets. Accounts receivable are debts owed to the business by outside parties or clients. Inventory is any form of raw materials as well as finished and unfinished products that are sold to clients and customers.
2. Non-current assets
Non-current assets are assets that cannot be easily converted into cash within a year. This would include business-related products and properties such as physical offices, real estate owned, technology, and machinery or equipment on site. Patents and copywritten products would also fall into this category.
3. Current liabilities
Like assets, current liabilities are debts or expenses due to be paid within a year's timeframe. Accounts payable, bank loans and lines of credit, and employee salaries are good examples of current liabilities.
Accounts payable are accounts that a business owes to outside clients. Bank loans are business liens that are placed through financial institutions with the purpose of borrowing for business capital.
4. Non-current liabilities
Non-current liabilities, or long-term liabilities, are liabilities that need to be paid after a year or 12-month timeframe. Real estate loans, vehicle loans and equipment leases are considered non-current. Payments made on liens within those 12 months are considered current liabilities, with the loan balances and payoff options being listed as a non-current liability.
5. Owner's equity
Owner's equity is what is left over after subtracting assets from liabilities. For most businesses, equity is made up of retained earnings, which is income that belongs to the company. Positive retained earnings mean the business is profitable and in good financial shape. Negative retained earnings can mean the business is in financial distress.
Owner's equity can be another part of equity and is the amount of money that was invested in a business during the covered period by a business owner. Generally, this only applies to smaller businesses who are getting funding from an owner. Larger firms generally do not get funding from an owner, but rather use other forms of financing. To determine the best way for your company to handle owner's equity on your books, it's best to talk with your financial advisor or accountant.
Analyzing a balance sheet
Asset vs. liability
What you owe or are owed, and what you have in total, are the core elements of a business's financial success: you want to have more than you owe. By looking at each line item under assets and liabilities you can see where you might need to make adjustments.
Balance sheet financial ratio
Ratio analysis is a method of analyzing multiple parts of a company's financial statements, and the balance sheet is used most often to do this. Different types of ratio analyses are used to understand multiple aspects of a business, such as overall profitability, liquidity, and solvency. Two of the most popular ratios used to analyze a small business balance sheet are:
- Liquidity ratio: Liquidity is one type of ratio analysis and refers to the cash you have on hand to pay expenses or repay debts. You can determine your liquidity ratio by dividing current assets by current liabilities. A ratio over 1.0 means you have more assets than liabilities and have a better chance to pay your expenses.
- Profitability ratio: Are you retaining earnings, or do you have negative retained earnings? This is a simple way to gauge profitability.
Because some of this is complicated and can involves a lot of mathematical formulas, it's always a good idea to review your balance sheet with an accountant or your banking relationship manager.
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