A Balance Sheet is a snapshot of a company’s financial position on a particular day. Usually a Balance Sheet is created at the end of a fiscal period and/or at the end of every month or quarter to measure progress. It is a very useful financial statement to help the management team assess the net worth of a company. The accounts represented on a Balance Sheet will differ for every company, as each business is unique in its own way.
The following is a balance sheet illustration to use as a guide for reading a Balance Sheet:
Keep in mind the following formulas:
Assets are items a business owns that could be converted to cash, while Liabilities represent the debt to finance the company’s assets as well as costs payable for operating a business. If you were to subtract liabilities from assets you would be able to calculate the owner’s equity or shareholders’ equity. A positive figure in the total equity means a company has a positive net worth, while a negative total means the opposite.
What is the significance of the net worth position?
The net worth position helps business owners and potential investors assess the value of a company. A negative net worth could be dangerous for small business owners, because they could have a difficult time to secure financing. Or worse, if they decide to close their business they won't have enough cash to pay off their creditors/ lenders. However, if a company has a positive total equity the business owners could potentially secure additional capital, sell a part or all of their business, and/or issue dividends.
The Balance Sheet on both sides is listed from short-term to long-term. Assets are usually listed in order of liquidity (from highest to lowest probability), whereas the liabilities are listed by anticipated length of time to pay off debt (short-term to long-term). Therefore, it is possible from a bird’s eye view to conclude whether a company is capable of paying off their outstanding loans.
Balance Sheets are connected to Income Statements through the Owner’s Equity portion. The ‘Opening Balance Equity’ represents the initial investment into the company and the ‘Retained Earnings’ is the cumulative summary of a company’s consecutive earnings since the beginning. Dividends may also be represented within the Retained Earnings total (via Statement of Retained Earnings), thus not needing a heading of its own. However, for small business owner’s it may be beneficial to show total dividends awarded on the Balance Sheet.
Balance Sheets are great for comparing a business’s worth over several periods by calculating various financial ratios. Financial ratios are used to determine a company’s profitability, liquidity, activity, and debt management.
An example would be determining a company’s liquidity by calculating its working capital. For the ABC Company their working capital is equal to $1,980 (Current Assets 289,098 – Current Liabilities 287,118). If you are familiar with financial ratios you will be able to measure any companies’ efficiencies by reviewing their Balance Sheet.
Although Balance Sheets are a financial snapshot on a particular day it might be able to show where a company is heading. It is possible that a company can change their net worth drastically with only a few significant transactions. Therefore, it is important to review numerous Balance Sheets before drawing any costly conclusions.