It’s all about balance (sheets)
Business owners should know the components of balance sheets and how others will use balance sheets. Find out more from The Tax Institute.
The balance sheet is one of three important financial statements that your business prepares either annually or quarterly. It is a snapshot in time of a business’s financial health and a tool for banks, investors and even its owners to determine the liquidity of the business. The balance sheet is often referred to as a statement of financial position or statement of net worth and, although they contain the same basic elements, each company’s balance sheet looks a little different.
Balance sheets are important because banks, investors and even the government use the balance sheet when evaluating whether to provide capital to a business. Banks need to know if a business will be able to pay back a loan, investors need to know if they can get a return on their investment, and the government needs to know about the business’s financial position when determining whether to award grant money.
Components of balance sheets include assets, liabilities, and owner’s equity
To begin, the balance sheet is based on the following basic accounting equation:
Assets = Liabilities + Owner’s Equity.
The balance sheet is divided into three sections: assets, liabilities and owner’s equity.
Balance sheet part one: Assets are items of value the owners or the business own
Assets are items either the owners or the business itself own that have value. When creating the balance sheet assets are divided into two different categories: current and noncurrent assets. Current assets, sometimes referred to as short-term assets, are the most liquid assets such as cash, accounts receivable, prepaid expenses, and inventory. These are items that can be quickly converted to cash if need be and are normally used or exhausted in under a year.
Noncurrent assets, sometimes referred to as long term or fixed assets, are less liquid and include items such as buildings, land and equipment. These items can’t be easily converted to cash, and most of these items will be held for longer than a year.
The balance sheet shows subtotals for current assets and long-term assets, and these figures are added to get total assets, as shown in example 1.
Balance sheet part two: Liabilities are what the business owes to others
Liabilities are how much a business owes to others. Like assets, liabilities are divided into current and noncurrent (long-term) liabilities. Current liabilities are those that are due within a year and include accounts payable, short-term debt and the portion of long-term debt that is due within a year. Noncurrent or long-term liabilities are those that are not due within a year and include items such as long-term contracts, mortgages, leases and long-term bonds payable. As with assets, there are subtotals for current liabilities and long-term liabilities, and these subtotals are added to give total liabilities, as shown in example 2.
Balance sheet part three: Owners’ equity is owner investment and retained earnings
The final component of the balance sheet is owner’s equity. This portion of the balance sheet is comprised of the owner’s investment in the business and the retained earnings of the business. The owner’s investment section will look different based upon the form of the business (i.e., sole proprietorship, partnership or corporation). For example, if a business is run as a C corporation, the owner’s investment section will be comprised of common and preferred stock and retained earnings. The section may list the par value of each share of stock along with the number of shares outstanding. On the other hand, a business operating as an LLC may just list owner’s investment as in example 3.
Finally, the owner’s equity section will include retained earnings. Retained earnings are the earnings of the business that have not been distributed to the owners. For example, a C corporation’s retained earnings are the amount of current and prior-year earnings of the business that have not been distributed as a dividend. Items that contribute to net income, such as revenues, increase retained earnings, and items that contribute to a reduction in income, such as operational expenses or distributions to owners, reduce retained earnings. Retained earnings and the owner’s investment make up the total owner’s equity. Total liabilities are added to total owner’s equity must be the same total as net assets. Keep in mind that total assets must equal total liabilities plus owner’s equity.
Note: Accounting software or a bookkeeping service, if used, will be able to provide a business with the information discussed above and may even prepare the statements.
How is the balance sheet used?
The balance sheet is necessary to generate four different measures: liquidity, efficiency, leverage and rate of return. The following discussion is a general description of these ratios and it’s important to note that their usefulness may vary by the type of business and industry.
Liquidity measures the ability of a business to pay its bills
The more liquid the business, the more likely it is that banks will lend the business money. Liquidity is typically measured using the Current Ratio (CR), sometimes called the working capital ratio, which is:
Current Ratio = Current Assets / Current Liabilities
A positive current ratio tells lenders that the business is likely to be able to cover its short-term obligations and be less likely to default. This, in turn, makes access to capital easier.
Efficiency tells how well the business manages assets
Efficiency tells others how well a business manages its assets. To measure this, compare revenue to assets using an income statement. Efficiency is usually measured using the Fixed Asset Turnover Ratio (FATR) which is:
Fixed Asset Turnover Ratio = Net Revenue / Fixed Assets
This tells potential sources of capital how well fixed assets generate revenue over the course of the year. Again, the higher this ratio is, the more likely the business will have access to capital because it shows that assets are well-managed. Also note that the ratio does not indicate the ability of a business to generate profits.
Leverage lets others know how much debt the business uses to finance operations
Leverage is used to let others know the proportion of debt the business uses to finance its operation. The most common measure of leverage is the Debt to Equity (D/E) ratio which is:
Debt-to-Equity = Total Liabilities / Owner’s Investment
This lets others know how much financial risk the business takes by evaluating where the business gets capital. The lower the ratio the less debt and more equity used to finance the business. Ideally, businesses have more equity than debt, but this isn’t always possible, especially for new businesses that may be perceived as risky.
Rate of return tells investors what their return on investment is for the period in question
The final measure that is often used is rate of return. This is measured by using the balance sheet and income statement to calculate Return on Equity (ROE) which is:
Return on Equity = Net Income / Owner’s Investment
This tells investors how likely it is that they will get a return if they invest in. The higher this number, the more likely it is that a business can get investors which, in turn, can help the other measures such as leverage since equity is increasing.
It’s important not to focus on only one of these measures when evaluating a business since no single one tells the whole picture. It’s also important to understand that before seeking potential capital sources business owners should evaluate these measures and if possible, address any issues before pursuing a particular route.
Here to help
The balance sheet can be a helpful tool for a business and even make getting access to capital easier. Business owners should know its components and how others will use it to evaluate the business’s financial position. Finally, preparing financial statements is an important step to take either quarterly or annually so business owners know where the business stands and what it can improve on.
Need more help with business tax and bookkeeping? Make an appointment with a Block Advisors small business certified tax professional today.