A balance sheet is one of the three main financial statements in accounting. It provides the keys to unlocking a company’s future success. That is why knowing how to read one is foundational in business.
In this article:
- What is a balance sheet?
- Balance sheet accounts: assets vs liabilities vs equity
- The balance sheet equation
- Balance sheet financial ratios
What Is A Balance Sheet?
A balance sheet tracks all your business accounts. It is a dynamic view of your chart of accounts, showing constant updates in operational activity. The balance sheet follows the accounting equation and consists of three sections: Assets, Liabilities, and Equity.
The Accounting Equation
Assets = Liabilities + Equity
Balance Sheet Example
The format of the balance sheet replicates the accounting equation. Assets are always on the left, liabilities are on the right, and equity is situated underneath liabilities. This equation should always be in balance, meaning both sides should always be summarized equally.
See the balance sheet example below:
By calculating the accounting equation on a balance sheet you will see whether your assets are covering your liabilities. As well as the book value of your company after all liabilities have been met.
Balance Sheet Accounts: Assets vs Liabilities vs Equity
As stated above the balance sheet monitors 3 different categories of your business: Assets, Liabilities, and Equity. All accounts on your balance sheet follow your chart of accounts and fall into one of these three categories. Your specific chart of accounts will depend on your industry and how you organize your accounting.
Balance sheet accounts are called real or permanent accounts because they are in constant flux. The ending balance of the period carries over to the next period as the opening balance, this is true at the end of the year as well. Unlike income statement accounts which zero out at the end of each year, with your total profit/loss added to equity on the balance sheet.
What Is An Asset Account?
Let’s talk about your assets. Asset accounts are what a company owns, that has a calculable value and adds to the business’s wealth. These accounts are considered positive when valuing the balance sheet. There are two types of asset accounts: current assets and noncurrent assets. When you combine current and noncurrent assets, they equal a company’s total assets.
Current Assets vs Noncurrent Assets
Current assets will be used or sold within a short amount of time, generally within a year. They are favorable because they offer cash liquidity to a business, meaning they can be converted into cash quickly.
Noncurrent assets are the opposite and cannot be converted to cash easily. They are also referred to as fixed or capital assets because they are something a company intends to keep for a fixed amount of time and they add to business capital.
Here is a current and noncurrent asset accounts list:
|Current Asset Accounts||Noncurrent Asset Accounts|
|Cash||Property or Real Estate|
|Inventory||Intangible Assets (Patents)|
|Accounts Receivable||Long-term Investments|
|Marketable Securities||Intellectual Property|
What Is A Liability?
Liabilities are what a business owes. They mean that the business must meet an obligation, or pay an expense. Liabilities are viewed as negative when valuing the balance sheet. Liability accounts are broken down into two categories: current liabilities and noncurrent liabilities. When you combine current and noncurrent liabilities, they equal a company’s total liabilities.
Current Liabilities vs Noncurrent Liabilities
Current liabilities are debts owed within a year. Noncurrent liabilities are owed over a longer period. Liabilities don’t have to be monetary, it is whatever is owed, so they can also be the promise of goods or services to a customer.
Here is a current and noncurrent liability accounts list:
Owner's Equity Accounts
This is the last section on a balance sheet, and these accounts generally take up the least amount of space. Business equity is the cumulative stake owners and/or shareholders have in the business. These accounts track how much owners have started the business with, and how much they earn or withdraw from the business.
If a company cannot pay its liabilities with assets, it dips into shareholder’s equity. When a company is profiting, each owner has rights to a certain amount of equity, after all liabilities have been accounted for.
Here is a list of equity accounts:
The Equity Method vs The Cost Method
Some business situations call for the equity method of accounting. This is when an investing company or holding company owns 20-50% of the voting stock of another company. Since this is considerable influence over the subsidiary company, the parent company recognizes their percentage of profit and loss as equity on their balance sheet. This differs from the cost method, where the investment is recognized as an asset. The subsidiary company does nothing different in their accounting, still maintaining records of the entirety of their profit and loss.
Balance Sheet In Accrual Accounting vs Cash Accounting
In accrual accounting, revenue is recorded as it is earned and expenses as they are incurred. So with this method of accounting your balance sheet shows all monetary dealings, most importantly what is coming and going in the near future.
For Example: Accounts receivable show sales earned, but you haven’t received revenue yet.
Due to the nature of cash accounting, recording transactions as cash literally changes hands, the balance sheet is not as valuable. It will only show you sales made and bills paid, and for that, it is very similar to your cash flow statement.
The Balance Sheet Equation
As mentioned before, the balance sheet follows the accounting equation aka the balance sheet equation. All accounting is based on this master formula which can be used in 3 different ways:
Balance Sheet Equations
Assets = Liabilities + Equity
Owner’s Equity = Assets – Liabilities
Liabilities = Assets – Owner’s Equity
Debits And Credits On The Balance Sheet
The balance sheet gets its name from balancing debits and credits. For each business transaction, you are debiting and crediting an asset, liability, and/or an equity account. You do this to track what is going out and coming into your business. Every debit always has an equal credit and they should always match per transaction, that way the equation remains in balance.
Bookkeeping is the art of entering those debits and credits into accounts. A debit is how you used your funds—what you received or purchased; a credit is the source of your funds—what you gave or where the money came from. If at any point this equation is out of balance, there is an error in bookkeeping that needs to be remedied.
Balance Sheet Accounts: Normal Balance
All accounts on the balance sheet have a normal balance. This is when the account is behaving the way it should. How an account behaves depends on the type of account. Each account in your chart of accounts has a normal balance with a debit or credit.
Here are how debits and credits work in each type of account:
It is an atypical event when an account has the opposite of its normal balance. Usually they can signify one of these bookkeeping scenarios:
- A journal entry was recorded in the wrong account.
- A reversal journal entry is made to an account that has been zeroed out for the year, at the start of the new year.
- A reversal journal entry is recorded before the adjusting entry (should be temporary).
Balance Sheet Accounting Example
A health food company buys a case of acai berries for $500, to make its signature smoothie powder.
A couple of accounting entries would be made. One in accounts payable (liability), and one in inventory (asset). Acai berries are inventory received, that is a $500 debit; it will be paid from accounts payable, that is a $500 credit. On the balance sheet, both accounts are increasing, assets and liabilities are equal so the accounting equation remains in balance.
What Are Contra Accounts?
Contra accounts are used to keep accounting records clean. Instead of recording all transactions in one account, a contra account stores all credits or debits in one area for clear reporting. They counter the normal balance of the account, and are always reported with the associated account. A contra account does not mean it is the opposite type of account.
For Example: a contra asset account is still an asset account. It would only record credits to the asset account and would be reported directly below the associated account on the balance sheet.
Insights From A Balance Sheet
The balance sheet shows the net worth of your business. Depending on the audience they can help pinpoint adjustments to a business to meet customer demands and hit targets. By and large, every party sees a balance sheet as a critique of business management.
Here is how different roles analyze specific parts on a balance sheet:
- Internal Management: is the business succeeding or failing in its mission? A balance sheet will tell management where to apply better oversight over different company functions.
- Investor: the balance sheet shows how liquid your assets are, and where they are tied up. An investor wants to know that you have working capital and are investing in future growth. In liabilities, they will be looking for loan balances which could affect earnings
- Lender: they will pay close attention to your current assets and current liabilities to understand your debt ratio. Your debt ratio plays a big part in whether you have room to take on debt.
- Auditors: they will look at balance sheets for reporting consistency. If a business must comply with GAAP accounting rules, then its reporting will be verified for accuracy and transparency.
Balance Sheet Financial Ratios
These 3 financial ratios are critical for determining the value of your business.
1. Net Working Capital
Working capital is the difference between a company’s current assets and current liabilities on the balance sheet. This shows whether a business can meet its responsibilities in the short term.
Net Working Capital (NWC) = Current Assets – Current Liabilities
Positive working capital means a business can fund its current operational needs, and invest in future growth.
High net working capital (NWC) means that a business has too much inventory or excess cash flow. That isn’t always bad, it could be temporary like an inventory order or peak sales season. If it is sustained over time, that indicates the cash should be invested, or a marketing push needs to happen to encourage sales.
2. Debt Ratio
A balance sheet will also help you understand your debt ratio, or whether your assets are covering your liabilities. This calculation is performed to assess whether you can take on debt, and the probability of repayment.
Debt Ratio = (Total Liabilities/Total Assets) x 100
This can be done with your total assets and liabilities, or your current assets and liabilities. The higher the debt ratio percentage the less wiggle room you have to pay a loan back.
3. The Acid Test Ratio (Quick Ratio)
This balance sheet ratio measures how easily you can manage your liabilities, in the short term. In addition to how liquid your assets are, except for inventory which can take longer to convert to cash.
Acid Test Ratio (ATR) = (Current Assets-Inventory)/Current Liabilities
You want to be at least 1.0 or higher. If you are below, that is not bad, it means you have debt. In that case the closer you are to 1.0 means you are managing business debt like a walk in the park.
Find Your Balance
A balance sheet is a window into your business because you can see your financial standing across all accounts. Monitoring how transactions affect your accounts keeps you in tune with the immediate future, and keeps your business viable. Your most ideal business picture is when liabilities on the balance sheet are covered by assets.