Balancing Sheets: A Small Business Owner's Guide

How to draw, prepare and use your balance sheet in decision making

A balance sheet is one of the fundamental financial statements that every small business owners need to understand. While typically presented as a photograph of your business’s financial status at any one point in time, the balance she explained in plain terms lets you look at what the business owns (its assets), what it owes (liabilities), and ultimately, owner’s equity. In this guide we dissect every part, explain what the numbers mean and provide some easy steps to prepare and analyse balance sheets to make better decisions.

What a balance sheet includes

A basic balance sheet consists of three sections: assets, liabilities and equity. Assets are resources, which the business owns and will provide future economic benefits. Liabilities are debts the company has to repay in the future. Equity is the owner’s residual interest in the company after liabilities are deducted from assets.

Assets are commonly classified into current and non-current elements. Current-assets are those which can be converted into cash within a period of 12-months, these includes cash in hand, accounts receivable and stock. Non-current assets (or fixed assets) are long-term investments, property, equipment and intangible assets such as trademarks; or goodwill.

Liabilities are also split up into current liabilities, those to be paid within a year (accounts payable, short term loans, accrued expenses) and long term liabilities for which time extends beyond that date(mortgages, long term loans, deferred tax liabilities). Owners’ equity includes an owner’s original investment, any retained earnings (the business profits that were not paid out as dividends to the owner(s)), additional contributions or withdrawals.

The balance sheet equation explained

The basic equation of our balance sheet is simple: Assets = Liabilities + Equity. This equality must always hold. If not, the balance sheet should be examined for posting errors and omissions or misplacements. The equation states that every asset is funded by borrowing or paid for with the money of the company’s shareholders (equity).

Why the balance of trade is important to small business owners

The balance sheet will provide a window into liquidity, solvency and capital structure. Liquidity is the most important measure of a company’s ability to meet its short-term obligations. High ratio of current assets to current liabilities is more favorable in the short term perspective. Solvency tests the long-term sustainability of the business — can it pay off long-term debts and keep running? Equity levels show what proportion of a business is funded by owners, compared with lenders.

Balancesheet based pragmatic metrics

The following is a ratio analysis translating the balance sheet:

• Current ratio = Current assets ÷ Current liabilities. A ratio greater than 1 usually suggest the business can meet short-term obligations — but norms vary by industry.
• Quick ratio = (Current assets – Inventory) / Current liabilities. This test is stricter and does not allow for inventory to be counted, if it would be more difficult to convert into cash in a short period of time.
• Debt-to-equity ratio = Total liabilities / Total equity. This is a measure of financial leverage; the higher the figure, the more debt is used to finance assets.
• Tracked over time, these metrics indicate trends and warning flags before they flare into crises.

Simple balance sheet example Step-by-step guide.

Pick a date for reporting:

The balance sheet is like a snapshot. Choose an end of a month, quarter or year.

List and value assets:

Table cash balances (as noted above), receivables, inventory (at the lower of cost or market as defined by accounting policy) and fixed assets (net of depreciation).

Record liabilities:

Write down all your short and long-term debts. Don’t also forget your accrued expenses and any money you’ve delayed paying.

Determine equity:

Begin with owner’s investments, add retained earnings (minus profit withdrawn), minus owner's draw.

Do the math:

Verify that Assets = Liabilities + Equity. Trace transactions and reconcile differences.

For better balance sheets

• Retain supporting documentation: Number validation is easier with invoices, bank records, loan agreements and receipts.
• Use a consistent valuation method: Select a costing method for your inventory and don’t change it from period to period.
• Depreciate or amortize your assets gradually: Use a sensible depreciation method and keep track of accumulated depreciation separately.
• Reconcile often: Monthly reconciliation of bank accounts, receivables and payables decreases errors and increases the value of your balance sheet.

Common pitfalls to avoid

Blending companies’ private and company finances can complicate valuations of equity, assets.

• Not recording small recurring liabilities (such as accrued payroll taxes) can give the false impression of too little liability and too much equity.
• Inflating inventory or receivables without confirmation will make you think that you have more liquidity than you do and is a recipe for disaster.

Using the balance sheet in decision making

Balance sheets aren’t just compliance documents; they’re planning tools. Use them to:

• Calculate borrowing capacity: Lenders evaluate your balance sheet to assess risk. Solid equity and reasonable leverage enhance flexibility to obtain credit.
• Plan investments: Assess current assets against upcoming cash flow needs before making acquisitions of equipment or expansion.
• Define targets: Outline balance sheet targets, such as raising the current ratio or lowering the debt/equity ratio over a period of time.
• Growth monitoring: Monitor by how much assets, liabilities and equity change with changes in revenues. Normal growth should be a function of increasing assets and equity, with no outsized increases in liabilities.

When to involve a professional

Small business owners can certainly create straightforward balance sheets but turning to an accountant or planner for advice in thornier circumstances like tax planning, substantial purchases of capital equipment, merger issues, or the necessity to value intangibles is not a bad plan. Professionals are there to help enforce consistent accounting policies and standards, as well as ensure compliance with regulations.

Final checklist for owners

• Each balance sheet shall have a descriptive heading and include the date.
• Current and Non-current classification.
• Check figures, postings and documents for correct entry, mathematical accuracy and proper codes.
• Compare balance sheets across time to identify trends.

Knowing your balance sheet in plain English gives you the power to decide. Managing your cash, controlling debt and planning for sustainable growth can be significantly helped by having good balance sheets prepared regularly and reviewed. Think of the balance sheet as a strategic weapon, rather than just an accounting format, and it can become an indispensable tool for operating a healthy small business.