“It sounds extraordinary, but it’s a fact that balance sheets can make fascinating reading.” (Mary Archer)
A balance sheet reveals a company’s “book value” by showing what assets it owns, what liabilities it owes, and the equity or net worth attributable to its owners, at a specific point in time.
Because all resources or assets are either funded by borrowing (liabilities) or owner investments (equity), the fundamental accounting equation that underpins the balance sheet is:
Assets = Liabilities + Equity.
Key components of a balance sheet
- Assets are resources controlled by a company that are expected to generate future value. These include current assets, such as cash, accounts receivable, and inventory; and non-current or long-term assets such as property, equipment, trademarks, and patents.
- Liabilities are obligations the company owes to external parties. These include current liabilities, such as accounts payable, payroll and short-term loans, and non-current or long-term liabilities like bonds, leases and deferred tax liabilities.
- Owners’ equity represents the net worth of a company after liabilities are deducted from assets and includes retained earnings and contributed capital, among others.
What your balance sheet says about your business
The balance sheet is an important tool for evaluating your company’s financial health and operational efficiency.
By providing an overview of the assets and liabilities of the company and how they relate to each other, the balance sheet can help answer questions such as whether your company has a positive net worth, whether it has enough cash and short-term assets to cover its obligations, and how indebted it is compared to its peers.
The balance sheet will show when a company is borrowing too much money, if the assets it owns are not liquid enough, or if it has enough cash on hand to meet current liabilities.
For this reason, balance sheets are also used to secure capital, private equity funding, business loans or bank finance, as they allow stakeholders to assess the financial health of a company, its solvency, and its ability to repay short-term debts.
Using your balance sheet for better management
Business owners and managers, as well as other stakeholders such as lenders or investors, can leverage the balance sheet alongside other financial resources to enhance decision-making and performance.
When analysed over time or comparatively against competing companies, a balance sheet can reveal ways to improve the financial health of a company.
Financial ratios are important tools that draw data directly from the balance sheet and other sources and are used for fundamental financial analysis. Some common ratios include:
- Liquidity and solvency ratios show how well a company can pay off its debts and obligations using existing assets. They also allow for monitoring long-term liabilities to maintain sustainable debt levels.
- Financial strength ratios, such as debt-to-equity ratios, measure the relative proportion of debt and equity used to finance a company’s assets. A higher debt-to-equity ratio shows that a company is more heavily financed through debt, showing an increased leverage. These ratios indicate how financially stable a company is and how it is financed.
- Activity ratios focus mainly on how well the company manages its operating cycle, which includes receivables, inventory, and payables. These ratios can provide insight into the company’s operational efficiency.
The balance sheet can also contribute to planning for growth, for example, by showing if the company has the assets, resources and capacity to expand, or if reinvestment or additional funding is required.
We can provide and interpret your financial reports
A balance sheet is an invaluable strategic management tool – provided you know how to interpret it.
We can provide your company with this important business tool (along with other key financial reports such as your income statement and cash flow statement). We can also help you to understand and use these reports to make better business decisions, enhance financial health, and drive sustainable growth.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact us for specific and detailed advice.
© AccountingDotNews