How to Read & Understand a Balance Sheet
Also called the acid test ratio, the quick ratio describes how capable your business is of paying off all its short-term liabilities with cash and near-cash assets. In this case, you don’t include assets like real estate or other long-term investments. You also don’t include current assets that are harder to liquidate, like inventory. The current ratio measures the liquidity of your company—how much of it can be converted to cash, and used to pay down liabilities.
It is also possible to grasp the information found in a balance sheet to calculate important company metrics, such as profitability, liquidity, and debt-to-equity ratio. The purpose of preparing the Balance Sheet is to provide the company's financial status at any specific point in time to multiple stakeholders or potential stakeholders (management, shareholders, lenders, creditors). Unlike liabilities, equity is not a fixed amount with a fixed interest rate. Balance sheets are typically prepared and distributed monthly or quarterly depending on the governing laws and company policies.
Balance sheets are typically prepared at the end of set periods (e.g., annually, every quarter). Public companies are required to have a periodic financial statement available to the public. On the other hand, private companies do purpose of balance sheet not need to appeal to shareholders.
Balance Sheets are Needed for Financial Ratios
Balance sheets can be used to analyze capital structure, which is a combination of your business’ debt and equity. Lenders will factor them into their decisions when doing risk management for credit. These reports are also used to disclose the financial position and integrity of your business (i.e., the overall value of your company), which is vital for attracting investors.
What Is the Balance Sheet Formula?
A balance sheet explains the financial position of a company at a specific point in time. As opposed to an income statement which reports financial information over a period of time, a balance sheet is used to determine the health of a company on a specific day. Public companies, on the other hand, are required to obtain external audits by public accountants, and must also ensure that their books are kept to a much higher standard. If a company takes out a five-year, $4,000 loan from a bank, its assets (specifically, the cash account) will increase by $4,000. Its liabilities (specifically, the long-term debt account) will also increase by $4,000, balancing the two sides of the equation.
- Balance sheets can tell you a lot of information about your business, and help you plan strategically to make it more liquid, financially stable, and appealing to investors.
- If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholder equity.
- Balance sheets also play an important role in securing funding from lenders and investors.
- Shareholders’ equity will be straightforward for companies or organizations that a single owner privately holds.
Since they own the company, this amount is intuitively based on the accounting equation—whatever assets are left over after the liabilities have been accounted for must be owned by the owners, by equity. These are listed at the bottom of the balance sheet because the owners are paid back after all liabilities have been paid. Liabilities and equity make up the right side of the balance sheet and cover the financial side of the company. With liabilities, this is obvious—you owe loans to a bank, or repayment of bonds to holders of debt. Liabilities are listed at the top of the balance sheet because, in case of bankruptcy, they are paid back first before any other funds are given out.
Want to learn more about what’s behind the numbers on financial statements? Explore our eight-week online course Financial Accounting—one of our online finance and accounting courses—to learn the key financial concepts you need to understand business performance and potential. The balance sheet is just a more detailed version of the fundamental accounting equation—also known as the balance sheet formula—which includes assets, liabilities, and shareholders’ equity. A balance sheet provides a summary of a business at a given point in time. It’s a snapshot of a company’s financial position, as broken down into assets, liabilities, and equity. Balance sheets serve two very different purposes depending on the audience reviewing them.
Noncurrent Liabilities
Balance sheets include assets, liabilities, and shareholders' equity. Assets are what the company owns, while liabilities are what the company owes. Shareholders' equity is the portion of the business that is owned by the shareholders. It is crucial to remember that some ratios will require information from more than one financial statement, such as from the income statement and the balance sheet. You will need to tally up all your assets of the company on the balance sheet as of that date. This means that the assets of a company should equal its liabilities plus any shareholders’ equity that has been issued.
Overall, a balance sheet is an important statement of your company’s financial health, and it’s important to have accurate balance sheets available regularly. Shareholder equity is the money attributable to the owners of a business or its shareholders. It is also known as net assets since it is equivalent to the total assets of a company minus its liabilities or the debt it owes to non-shareholders.
Companies usually prepare one at the end of a reporting period, such as a month, quarter, or year. It is important to understand that balance sheets only provide a snapshot of the financial position of a company at a specific point in time. Businesses should be wary of companies that have large discrepancies between their balance sheets and other financial statements. It may not provide a full snapshot of the financial health of a company without data from other financial statements.
Accounts within this segment are listed from top to bottom in order of their liquidity. They are divided into current assets, which can be converted to cash in one year or less; and non-current or long-term assets, which cannot. Each category consists of several smaller accounts that break down the specifics of a company's finances. These accounts vary widely by industry, and the same terms can have different implications depending on the nature of the business. Companies might choose to use a form of balance sheet known as the common size, which shows percentages along with the numerical values.
When used with other financial statements and reports (such as your cash flow statement), it can be used to better understand the relationships between your accounts. In order to get a more accurate understanding of the company, business owners and investors should review other financial statements, such as the income statement and cash flow statement. In order to get a complete understanding of the company, business owners and investors should review other financial statements, such as the income statement and cash flow statement. This financial statement lists everything a company owns and all of its debt. A company will be able to quickly assess whether it has borrowed too much money, whether the assets it owns are not liquid enough, or whether it has enough cash on hand to meet current demands. Investors can get a sense of a company's financial well-being by using a number of ratios that can be derived from a balance sheet, including the debt-to-equity ratio and the acid-test ratio, along with many others.
The second is earnings that the company generates over time and retains. Long-term assets (or non-current assets), on the other hand, are things you don’t plan to convert to cash within a year. Balance sheets of small privately-held businesses might be prepared by the owner of the company or its bookkeeper. On the other hand, balance sheets for mid-size private firms might be prepared internally and then reviewed over by an external accountant.
