As a business owner, the balance sheet is one of the most important documents you can use to evaluate the financial health of your company and make key decisions. Unfortunately, because some business owners may not fully understand the contents of this document, they may overlook it entirely. Below is some basic information about the balance sheet, as well as some tips to help you better understand this document.
What Is a Balance Sheet?
A balance sheet is a document that provides a quick look at the company’s financial situation at a given time. This statement includes the details of the company’s current assets, liabilities and shareholders’ equity. Each of these categories is broken down into smaller pieces, allowing you to see which pieces make up the largest portion with each category.
Balance Sheet vs Income Statement
A balance sheet is different from some of the other statements that may be used to evaluate the company’s finances, including the income statement, which may also be called the profit and loss statement . For example, while the balance sheet provides information about the company’s financial situation at a specific moment, the income statement provides information about the company’s finances over time. Although it may initially seem like the income statement provides more information than the balance sheet, this is not necessarily the case. If you understand how to read the balance sheet properly, you can gain just as much insight or even more than you could from reading income statements.
How to Read a Balance Sheet
Reading a balance sheet may be simple, but putting the information to good use is more of a challenge. At first glance, a balance sheet gives you only a basic picture of your company’s finances on the day it is created. In fact, because of the time it takes to process income and payments, the information on a balance sheet is rarely “real-time” information. Nonetheless, learning how to read balance sheets is still highly beneficial. To gain the most insight from reading balance sheets, follow these tips.
- Have a “comparison” mindset.
- The best way to use balance sheets to your advantage is to learn to compare the information on multiple versions of this document from different periods of time. This will allow you to identify important trends and gain insight into your company’s financial health.
- Look at changes to assets and liabilities.
- Over time, your company’s assets and liabilities may increase or decrease. Individual assets or liabilities may change in value, or new assets or liabilities may be added to the list. Pay attention to these trends to determine how your company is changing. For example, if your assets are growing more than your liabilities, the company is moving in the right direction. However, if liabilities are growing while the value of assets decreases or remains stagnant, changes need to be made.
- Track trends in equity.
- In addition to a summary of assets and liabilities, your balance sheet also includes information about equity. A single snapshot of equity doesn’t offer much information, but watching the way equity changes over time can provide valuable information about the growth of the company. In general, you want to see equity increase as time goes on.
- Track liquidity.
- Your business’s liquidity, which is essentially its ability to convert assets to cash and cover debts. To determine liquidity, you must compare your liquid assets to the company’s liabilities. Using the information from your balance sheet, you can calculate the “current ratio,” which gives you an easy way to track this metric. To calculate this ratio, simply divide current assets by current liabilities. In general, a ratio greater than one is preferable. However, if the ratio is much higher than one, it may indicate that the business isn’t leveraging its assets as well as it could.
The balance sheet can be confusing, but once you understand this document and its purpose, it can also provide valuable insight. With these tips, you can use your balance sheet to its greatest advantage.