A balance sheet or statement of financial position is a financial statement that shows the financial position of the business to the owner and other stakeholders such as creditors and shareholders. It provides a good image of the health of the business. It shows the assets (what the business owns), liabilities (what it owes), and the net worth of the business (owner’s equity) at a specific point in time.
Importance of balance sheet to the business owner
It is critical for every small business owner to know how to use a balance sheet. This financial statement helps him to understand the state of his business so that he can track finances. A business owner who understands the balance sheet can quickly see the financial capabilities and weaknesses of the business and dedicate resources to areas that need improvement.
How to understand a balance sheet
An easy way to understand a balance sheet is to differentiate between assets and liabilities. Assets are owned by the business and may be tangible or intangible. They add value to the business. Liabilities are obligations of the business to transfer an asset to another party. Liabilities deplete the value of the business and should be kept to a minimum.
Everything that is owned or is within the business and has monetary value is usually included in the balance sheet. All these things are put into four categories. Things that can be sold or liquidated within one year are called current assets. Things can require more time to liquidate such as property or machinery are called fixed assets.
Current liabilities are things that the business should pay in the short-term (within one year) such as taxes due and money owed to suppliers. Long-term liabilities include what the business has to pay after one year and capital and reserves. Total assets are found by subtracting total liabilities from the value of all assets after depreciation and interest have been accounted for.
What the business owner should aim for
Current assets exceed current liabilities so that the business owner can pay his bills. In an ideal situation, the value of current assets should be twice the value of current liabilities. The business can cater for unexpected costs and is considered financially healthy. If the value of current assets is less than that of current liabilities, the business is unhealthy and struggling financially.
To check for correctness of calculations, the business owner needs to see that total assets always equal the value of liabilities plus owner’s equity. The sheet is then said to be ‘balanced’. This equality is not a coincidence. If accountants and bookkeepers enter information correctly into a properly working accounting system, the balance sheet balances.