It makes perfect sense for online business owners always to know where their business stands financially. However, manually keeping track of every penny that flows through is near-impossible save for the least active enterprises.
To make it easy to get a clear perspective of your business’s current financial position, you’ll need a balance sheet and know how to read a balance sheet.
Therefore, knowing how to read a balance sheet is essential for your business. You can either do this on your own or hire a professional service to create monthly balance sheets for your business.
What is a Balance Sheet?
The balance sheet is one of the three primary financial statements:
- Income statements
- Cash flow statements
- Balance sheets (statements of financial position)
A balance sheet enables you to evaluate your company’s net worth. It contains a breakdown of your company’s assets, liabilities, and shareholders’ equity (if your business is a single-person LLC, then you are the only shareholder).
While the first two types are pretty self-explanatory, balance sheets may not be so obvious.
In simpler terms, a balance sheet tells you how much your company owes and how much it is owed at a specific point in time. For this reason, the balance sheet is also referred to as the ‘statement of financial position.’
Why Is Balance Sheet Important for Your Online Business?
First of all, depending on your company structure, you may be obliged to have a balance sheet by law. The federal or the state government may require you to send all three basic types of statements to tax and regulatory authorities.
Another reason why a balance sheet is essential is liquidity – the ease with which you can spend business assets (e.g., cash). In short, your assets should always cover your liabilities, and it’s your balance sheet that can tell you if this is possible.
Together with the income statement, the balance sheet can tell you how efficiently your assets are used. For instance, you can get a clear perspective of how your assets affect your revenue.
Also, your balance sheet indicates your business’s leverage. Since it contains both debts and equity, comparing the two will give you an idea of the financial risk.
Lastly, a balance sheet is essential when determining the net worth of your company. Should you want to sell your online business, this is the first thing that potential buyers will want to know.
The Elements of a Balance Sheet
To learn how to read a balance sheet, you first need to know all of the sections found on a typical balance.
Every balance sheet has three main sections: assets, liabilities, and shareholders’ (owners’) equity. Each category is crucial to understanding your balance sheet, so here’s what they mean:
Assets
An asset is anything your company owns that has economic value. Thus, you use assets to operate your business. In a balance sheet, you’ll have two types of assets:
Current Assets
Current assets are what you use to operate your online business on a day-to-day basis. They can easily be converted into cash within a year. Apart from cash and cash equivalents, current assets include inventory and accounts receivable (i.e., outstanding invoices).
Non-Current Assets
Non-current assets can’t be converted into cash as quickly as current assets. It may take a year or more for non-current assets to turn into money that you can freely use. Non-current assets can be further broken down into tangible assets (e.g., equipment, property, building, etc.) and intangible assets (e.g., trademarks, patents, brands, etc.).
Liabilities
Liabilities are what your company owes to other entities. Your online business must be able to cover liabilities within provided deadlines. Depending on the period within which you need to pay them, there are two types of liabilities:
Current Liabilities
Current liabilities come due within one year. The types of current liabilities are accounts payable, debt financing, rent payments, and more.
Long-Term Liabilities
Long-term liabilities are any liabilities that will take more than one year to pay off in full. These include long-term debts, deferred tax liabilities, leases, provisions for pensions, and bonds payable.
Equity
Equity (owners’ equity or shareholders’ equity) is the amount of money that remains when all liabilities are accounted for. It consists of two elements: investments made by owners in return for shares and earnings that the business has generated.
If the company receives any donations, they are also considered equity. Technically speaking, equity determines the net worth of a business, not to be confused with its valuation, which may depend on the evaluator and a slew of other factors.
The Balance Sheet Formula
Before we dive into explaining how to read a balance sheet, you should first know the relations between assets, liabilities, and equity. In fact, there is a simple formula that will help you understand these relations:
Assets = Liabilities + Shareholders’ Equity
For example, let’s say your online business has to pay a $500 loan and that the owners have invested $1,500 in the business. This means that your assets have to equal $1,000:
Liabilities (-$500) + Equity ($1500) = Assets ($1000)
If your balance sheet doesn’t balance, you will have to hunt down the source of the discrepancy. Of course, you can rearrange this equation to get your expected total liabilities and equity:
- Liabilities = Assets – Equity
- Equity = Assets – Liabilities
How to Read a Balance Sheet
Now, let’s finally see how all these elements and formulas apply to balance sheets.
The Basics
Every balance sheet is divided into two sections. The first section lists the assets, while the second covers liabilities and shareholders’ equity.
Assets are organized so that the most liquid assets appear first, with the most minor liquid assets at the bottom. The same principle applies to liabilities.
Ratio Analyses
You can manipulate financial ratios to gain insight into your business capabilities and the degree to which it can meet its obligations. For instance, the working capital ratio is the relative size of current assets and current liabilities. Furthermore, debt-to-equity shows you the percentage of debt-funding and equity-funding for your online business.
Activity ratios (or efficiency ratios) serve to show the efficiency of business operations and how well they are implemented to generate revenue. These include accounts receivable turnover ratio, inventory turnover ratio, days payable outstanding, and more.
Use Accounting Software to Your Advantage
When it comes to reading those multi-faceted and difficult to understand balance sheets, one of the things that you can do to make your life as easy as possible is to use a good piece of accounting software.
Sure, it definitely helps to be able to read a balance sheet without outside assistance, but with that being said, we already rely on so much technology that there is no point in neglecting the technology that does all of the work for you, or at least most of it.
A good piece of accounting software can not only read your balance sheet for you, but also provide you with all of the most crucial information about it, such as if you are in the green or in the red, and of course, much more.
In case you need some help getting started, three of the best pieces of accounting software out there, the most user-friendly and easy to navigate ones, include QuickBooks, Zoho, and Freshbooks.
FAQ
Now that you know the balance sheet basics let’s take a look at some common questions.
How Do You Know if a Balance Sheet Is Correct?
The balance sheet is correct when it’s in balance, meaning the balance sheet equation checks out – total assets equal total liabilities and shareholders’ equity. Once again, here’s the balance sheet formula:
Assets = Liabilities + Shareholders’ Equity
If your balance sheet doesn’t balance, you’ve probably omitted an asset or liability. Perhaps you’ve skipped over some petty transactions, inserted incorrect data, forgot to make a change in inventory, or made some other technical error.
What Items Appear on a Balance Sheet?
We’ve already explained what assets, liabilities, and shareholders’ equity are. These are the main items on every balance sheet. However, all three categories contain subcategories of things, depending on the size and complexity of your business.
Here’s a list of the most common items for each category:
Assets
- Cash and cash equivalents
- Marketable securities
- Prepaid expense
- Accounts receivable
- Inventory
- Intangible assets
- Tangible assets
Liabilities
- Accounts payable
- Short-term debts payable
- A part of long-term debt
- Accrued expenses
- Income taxes payable
- Deferred revenue
- Bonds payable
- Deferred income taxes
Equity
- Share capital
- Retained earnings
- Net income and dividends
Is Capital an Asset?
The term ‘capital’ commonly refers to the value of assets (usually money) that the owner/shareholder(s) have invested in a company. There are three different types of capital:
- Working capital – the difference between current assets and current liabilities
- Equity capital – the ownership value of the shareholders
- Debt capital – the amount of money that the business has raised
So, categorizing capital as an asset is not that simple. Working capital is considered an asset because you can use it to operate your online business.
In some cases, equity capital can be an asset too. For instance, if you’re the sole owner of your business, you’d treat your capital as an asset. You’ve invested your own money to start a business, and you’re not obligated to return that money to anyone.
On the other hand, equity capital can be a liability if the company’s shareholders are supposed to get their initial funds back. In accounting, you’ll find that capital is always viewed as a liability because it needs to be repaid to the owner.
Debt capital is always viewed as a liability since the money must be repaid one way or another.
What Are the Benefits of Looking at a Balance Sheet?
Creating a balance sheet is not just some requirement that the government has imposed on you as a business owner. Your balance sheet is crucial for evaluating your current financial situation and creating plans for future business operations.
Namely, the balance sheet shows your pending liabilities and current assets. You don’t get this type of information with cash flow statements or income statements. With a balance sheet, you have a clear view of where your assets will go in the near future. Therefore, it enables you to create safer business decisions.
When applying for a loan, lenders may require you to submit a balance sheet first. Investors will also want to look at your balance sheet to determine whether investing in your online business would be profitable. Also, it shows your company’s net worth.
Recommendations
Creating and reading a balance sheet on your own can be daunting, primarily if you’ve never dealt with accounting in the past. Fortunately, some services can do this for you at an affordable price.
Bench
If you’re wondering what to do with your balance sheet and bookkeeping in general, consider signing up for Bench. The company works exclusively with small businesses and has a team of professional accountants that will keep your books. Not only will they do the bookkeeping work for you, but they will also save you a lot of time.
So, What Makes Bench So Unique?
The first factor is reliability. When you sign up for Bench, three Bench employees will work with you to collect all your financial documents and information. Then, they will create and send you an income statement and a balance sheet every month.
Thus, you’ll have a snapshot of your business performance each month. Apart from this, they’ll generate financial reports periodically to give you additional insight into your cash flow.
Compared to other online bookkeeping services, Bench is one of the most affordable on the market. Plus, you can download their mobile app and manage all your bookkeeping on the go.
Balance the Books
Running an online business on your own can be too demanding at times. You have to manage your finances well for business sustainability. Balance sheets are essential as they give you detailed insights into your current financial position.
But now, you know how to read a balance sheet and keep track of your finances. And if you ever feel like you can’t find your way around your balance sheets, consider signing up for Bench.
