It’s important business owners and accountants understand how to read and interpret balance sheets. These documents offer a quick view of a business’s financial standing. Without this snapshot, business owners and accountants may make decisions that have negative repercussions on their companies’ financial standing.
A balance sheet is one of several major financial statements you can use to track spending and earnings. Also called a statement of financial position, a balance sheet shows what your company owns and what it owes through the date listed, as Accounting Coach stated. It displays this information in terms of your company’s assets, liabilities, and equity.
Assets are any items your business owns. Liabilities are payments your business needs to make. Equity is the amount your business’s shareholders own. On balance sheets, the assets are ideally equal to, or balance out, the liabilities and the equity.
There are two primary types of assets: current and noncurrent. Current assets are items your business has acquired over time that will be used up or converted into cash within one year, or one business cycle, of the date on the balance sheet. Prepaid insurance, accounts receivables, temporary investments, cash, inventories, and liabilities are considered current assets.
Noncurrent assets are any fixed assets or items your business owns. Things that fall into this category are office equipment, building property, land, long-term investments, stocks, and bonds.
Just like assets, there are current and noncurrent liabilities. Current liabilities represent payment obligations your company has to pay within 12 months of the date on the balance sheet. For example, an outstanding bill to an equipment supplier could be a current liability, as could salaries payable and income taxes payable.
Noncurrent liabilities are amounts your company has more than one year to pay. Bondholder and bank debt are considered noncurrent liabilities. You and your accountant can identify the liabilities on balance sheets by looking for the word “payable.” Again, these liabilities are some of the sources of your company’s assets.
Another asset source is equity. If you are the sole proprietor of your business, this is referred to as owner’s equity. If your business is a corporation, equity is called stakeholder’s equity. When all liabilities are subtracted from your company’s assets, the result is equity.
Equity is made up of paid-in capital and retained earnings. Paid-in capital is the amount each shareholder initially paid for his or her stock. Retained earnings refers to the amount of money your business didn’t sell to shareholders and instead reinvested into itself.
Why are balance sheets important?
It’s clear that balance sheets are critical documents because they keep business owners like you informed about your company’s financial standing. As Inc. magazine pointed out, many business owners fail to recognize their companies are in trouble until it’s too late. This is because some business owners aren’t examining their balance sheets. Typically, if the ratio of your business’s assets to liabilities is less than 1 to 1, your company is in danger of going bankrupt, and you’ll have to make some strategic moves to improve its financial health.
Balance sheets are also important because these documents let banks know if your business qualifies for additional loans or credit. Balance sheets help current and potential investors better understand where their funding will go and what they can expect to receive in the future. Investors appreciate businesses with high cash assets, as this insinuates a company will grow and prosper.