Bookkeeping 101: Understanding Your Balance Sheet

What are the components of a balance sheet?

The balance sheet presents your business’ assets, liabilities, and equity. Here’s what you should know about each of those categories, including exactly what they mean and what accounts they include.

Assets

An asset is something your business owns with an economic value that you can define in dollars. You can separate them into current and noncurrent assets based on their liquidity levels.

Current assets are those you expect to convert to cash within a year. In addition to your existing cash reserves and cash equivalents, that includes assets like the following:

• Inventory on hand that will turn into cash when you sell it
• Accounts receivable, which are unpaid invoices you expect to collect shortly
• Prepaid expenses, like rent, that you’ll use up over the next 12 months

Meanwhile, noncurrent assets are those you don’t expect to convert to cash within the next year. They’re typically much less liquid than current assets and provide value to your business over the long term.

Noncurrent assets include fixed assets, which are tangible, long-term assets with a multi-year useful life. Commonly referred to as property, plant, and equipment, they include things like machinery, vehicles, land, and buildings.

Noncurrent assets can also include intangible assets like goodwill and intellectual property that provide economic value for longer than 12 months.

Liabilities  

A liability is something of economic value that your company owes to another party. Like your assets, you can separate them into current and noncurrent, this time based on when you expect to fulfill the obligation.

Current liabilities include the credit accounts and financing arrangements coming due in the next year, such as business credit cards and short-term loans. It also includes accounts payable, which are outstanding invoices you’ll pay in the next few months and the opposite of accounts receivable.

Noncurrent liabilities, commonly referred to as long-term liabilities, are obligations that will remain outstanding beyond the coming year. For example, that would include notes payable, mortgage loans, and multi-year business loans.

Equity

Owner’s, shareholders’, or stockholders’ equity refers to your business’ net worth, or the difference between your assets and liabilities. It represents the value that would remain if you were to liquidate your business and pay off its outstanding debts.

A healthy business should have positive equity, meaning that its assets exceed its liabilities. A company that owes more than it owns is insolvent. Insolvent businesses have a higher likelihood of failing to meet their obligations, and lenders may be less likely to work with them.

Your equity account usually includes any contributions you’ve made to fund your business, the proceeds from any shares you’ve sold to investors, and any profits you’ve left in your company from previous years.

Balance sheet example.

Here’s an example of a balance sheet for a hypothetical business to give you a better idea of what yours might look like in practice.

Why is a balance sheet important?

Along with the income statement and cash flow statement, the balance sheet is essential for financial planning. Since it depicts your company’s assets, liabilities, and equity on a specific date, it’s best for analyzing the strength of your financial position.

One of the common ways small business owners can quickly extract information from their financial statements is through the use of financial ratios and metrics. Some popular examples for the balance sheet include:

• Current Ratio = Current Assets/Current Liabilities: If this metric is below 1.00, your company has more current liabilities than current assets. That suggests your company may have an increased risk of failing to meet its upcoming obligations.
• Debt-to-Equity Ratio = Total Liabilities/Total Equity: This metric provides insight into your business’ capital structure. By comparing it to others in your industry, you can assess whether your debt levels are healthy. If it’s too high, you may need to stop borrowing money.

In addition to financial analysis, prospective creditors, investors, and business partners will typically ask for your balance sheet before deciding whether or not they want to work with you.

If your finances are complicated or you feel unconfident in your ability to build accurate financial statements, consider getting help from a Certified Public Accountant.