Your company’s balance sheet is a snapshot of your business’s assets, liabilities, and equity. Knowing how to read a balance sheet can help you make better decisions for your business.
The how to read a balance sheet for dummies is a guide that will help you understand your business’s balance sheet.
The income statement, statement of cash flows, and balance sheet are the three major components of a business financial statement. The balance sheet is the most misunderstood of these elements, but it’s also the most useful if you know how to utilize it.
The balance sheet gives you a picture of your company’s current financial situation. In one easy document, it outlines all of the company’s assets, liabilities, and equity. You may calculate your company’s net worth at any moment by subtracting liabilities from assets.
For more information, see our free printable Balance Sheet Template, and keep reading to learn about the many components of a balance sheet and why they are important.
A balance sheet’s components
A balance sheet is usually split into three sections:
The term “current assets” refers to assets that may be turned into cash within a year. Cash, stocks, accounts receivable, prepaid expenditures, and inventory are common examples.
Fixed assets include physical assets such as equipment, machinery, vehicles, land and buildings, furnishings and fixtures, and leasehold improvements that are intended for long-term usage. Many additional assets don’t fall into either of these categories, therefore they’re shown as “other assets” on most balance sheets—things like long-term investment property, life insurance cash value, and employee pay.
Current liabilities are commitments that are due within a year.
Short-term notes payable (including lines of credit), current long-term debt maturities, accounts payable, accrued wages and other costs, and taxes due are all examples.
Long-term liabilities are company commitments that are due more than a year from now, such as bank debt or shareholder loans with longer maturities.
3. The equity of the owner
This is the total amount of money invested by shareholders in the company as well as the total amount of money earned by the company. Common stock, retained profits, and paid-in-capital are all part of the owner’s equity.
What is the purpose of a balance sheet?
Your balance sheet may offer a lot of information that can help you manage your finances better. For example, as previously stated, you may calculate your company’s net value by deducting your balance sheet obligations from your assets.
The capacity of your balance sheet to warn you to impending cash flow problems is perhaps its most helpful feature. If company owners don’t evaluate the effect of future expenditures on their cash flow after a very successful month or quarter, for example, they may be lulled into a feeling of financial complacency.
To assess if your business will have enough cash flow to fulfill current financial commitments, you may use two simple ratios calculated from the balance sheet:
The current ratio is
This metric determines if your business has adequate current (or liquid) assets on hand to pay payments on schedule and operate operations efficiently. It’s calculated by counting how many times current assets surpass current obligations.
It is preferable to have a greater current ratio. For inventory-carrying companies, a current ratio of 2:1 is usually regarded appropriate, but industry norms may vary greatly. For example, the permissible current ratio for a retailer differs from that of a producer.
The formula is as follows:
Current Liabilities / Current Assets
a fast ratio
This ratio is identical to the current ratio, except it does not take inventory into account. For non-inventory-carrying companies, a fast ratio of 1.5:1 is usually ideal, although as with current ratios, optimal quick ratios vary by industry.
The formula is as follows:
Inventory / Current Assets / Current Liabilities
Knowing your industry’s standards is an essential element of properly assessing your company’s balance sheet, which is why we provide small companies with free example industry reports. You may calculate the current ratio and quick ratio that are desired for your company type using the balance sheet provided in your industry’s report to get a better feel of how your own firm’s ratios measure up.
Get to know your balance sheet.
Most businesses should update their balance sheet once a quarter or whenever their lenders want one. Today’s accounting software systems will produce your balance sheet for you, but you must input correct data into the computer in order for it to provide meaningful statistics.
For companies who know how to utilize the balance sheet correctly, it may be a very helpful financial instrument. If you’re not as acquainted with your balance sheet as you’d want to be, now is a wonderful opportunity to learn more about how it works and how it may help you manage your finances better.
Download our Balance Sheet Template to quickly create your balance sheet, and read our article on The Key Elements of the Financial Plan for additional information on your company’s finances.
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