Balance sheets can help you see the big picture: the net worth of your small business, how much money you have, and where it’s kept. They’re also essential for getting investors, securing a loan, or selling your business.
So you definitely need to know your way around one. That’s where this guide comes in. We’ll walk you through balance sheets, one step at a time.
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Example H2 Example H3 Example H4 Example H5 Example H6 Tired of doing your own books?The balance sheet is one of the three main financial statements, along with the income statement and cash flow statement.
While income statements and cash flow statements show your business’s activity over a period of time, a balance sheet gives a snapshot of your financials at a particular moment. It incorporates every journal entry since your company launched. Your balance sheet shows what your business owns (assets), what it owes (liabilities), and what money is left over for the owners (owner’s equity).
Because it summarizes a business’s finances, the balance sheet is also sometimes called the statement of financial position. Companies usually prepare one at the end of a reporting period, such as a month, quarter, or year.
Nice. Your balance sheet is ready for action.
Because the balance sheet reflects every transaction since your company started, it reveals your business’s overall financial health. At a glance, you’ll know exactly how much money you’ve put in, or how much debt you’ve accumulated. Or you might compare current assets to current liabilities to make sure you’re able to meet upcoming payments.
You can also compare your latest balance sheet to previous ones to examine how your finances have changed over time. You’ll be able to see just how far you’ve come since day one. If you need help understanding your balance sheet or need help putting together a balance sheet, consider hiring a bookkeeper.
Here’s some metrics you can calculate using your balance sheet:
Next, we’ll cover the three most important ratios that you can calculate using your balance sheet: the current ratio, the debt-to-equity ratio, and the quick ratio.
Can your company pay its debts? The current ratio measures the liquidity of your company—how much of it can be converted to cash, and used to pay down liabilities. The higher the ratio, the better your financial health in terms of liquidity.
The ratio for finding your current ratio looks like this:
Current Ratio = Current Assets / Current Liabilities
You should aim to maintain a current ratio of 2:1 or higher. Meaning, your company holds twice as much value in assets as it does in liabilities. If you had to, you could pay off all the money you owe two times over.
Once you drop below a current ratio of 2:1, your liquidity isn’t looking so good. And if you dip below 1:1, you’re entering hot water. That means you don’t have enough liquidity to pay off your debts.
You can improve your current ratio by either increasing your assets or decreasing your liabilities.
Also called the acid test ratio, the quick ratio describes how capable your business is of paying off all its short-term liabilities with cash and near-cash assets. In this case, you don’t include assets like real estate or other long-term investments. You also don’t include current assets that are harder to liquidate, like inventory. The focus is on assets you can easily liquidate.
Here’s how you get the quick ratio:
Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
If your ratio is 1:1 or better, you’re sitting pretty. That means you’ve got enough quick-to-liquidate assets to cover all your short term liabilities in a pinch.
Similar to the current ratio and quick ratio, the debt-to-equity ratio measures your company’s relationship to debt. Only, in this case, the key value is your total equity.
This ratio tells you how much your company depends upon equity to keep running versus how much it depends on outside lenders. It’s calculated like this:
Debt to Equity Ratio = Total Outside Liabilities / Owner or Shareholders’ Equity
Generally speaking, a 2:1 ratio is considered acceptable. If the ratio gets bigger, you start running into trouble. It means your business relies heavily on debt to keep running, which turns off investors. The higher the ratio, the higher the chance that, in the event you need to pay off your debt, you’ll use up all your earnings and cash flows—and investors will end up empty-handed.
We’ll do a quick, simple analysis of two balance sheets, so you can get a good idea of how to put financial ratios into play and measure your company’s performance.
Summary:
Annie’s Pottery Palace, a large pottery studio, holds a lot of its current assets in the form of equipment—wheels and kilns for making pottery. Accounts receivable play a relatively minor role.
Liabilities are few—a small loan to pay off within the year, some wages owed to employees, and a couple thousand dollars to pay suppliers.
Annie’s is a single-member LLC—there are no shareholders, so her equity includes only her initial investment, retained earnings, and Annie’s draw($4,000).
Ratio analysis:
Current ratio: 22,000 / 7,000 = 3.14:1
Annie’s current ratio is very healthy. If necessary, her current assets could pay off her current liabilities more than three times over.
Quick ratio: 6,000 / 7,000 = 0.85:1
Her quick ratio isn’t looking so hot, though. Annie’s currently sitting just below 1:1, meaning she wouldn’t be able to quickly pay off debt.
Debt-to-equity ratio: 7,000 / 15,000 = 0.46:1
Annie’s debt-to-equity looks good. She’s got more than twice as much owner’s equity than she does outside liabilities, meaning she’s able to easily pay off all her external debt.
Final analysis:
Annie is able to cover all of her liabilities comfortably—until we take her equipment assets out of the picture. Most of her assets are sunk in equipment, rather than quick-to-cash assets. With this in mind, she might aim to grow her easily liquidated assets by keeping more cash on hand in the business checking account.
That being said, her owner’s equity is more than capable of covering her debt, so this problem shouldn’t be difficult to fix. It would be wise for Annie to take care of it before applying for loans or bringing on investors.
Summary:
A lot of Bill’s assets are tied up in inventory—his large collection of books. The rest mostly consists of long-term investments and intangible assets. (Bill’s Book Barn is famous among collectors of rare fly-tying manuals; a business consultant valued his list of dedicated returning customers at $10,000.)
He doesn’t have a lot of liabilities compared to his assets, and all of them are short-term liabilities. Meaning, he’ll need to pay off that $17,000 within a year.
Finally, since Bill is incorporated, he has issued shares of his business to his brother Garth. Currently, Garth holds a $12,000 share in the business, a little shy of half its total equity.
Ratio analysis
Current ratio: 30,000 / 17,000 = 1.76:1
Since long-term investments and intangible assets are tough to liquidate, they’re not included in current assets—meaning Bill has $30,000 in assets he can more or less easily use to cover his liabilities. His ratio of 1.76:1 isn’t great—it doesn’t leave much wiggle room if he wants to pay off his liabilities. But it isn’t terrible, either—he’s just shy of a healthy 2:1 ratio.
Quick ratio: 7,000 / 17,000 = 0.41:1
Bill’s quick ratio is pretty dire—he’s well short of paying off his liabilities with cash and cash equivalents, leaving him in a bind if he needs to take care of that debt ASAP.
Debt-to-equity ratio: 17,000 / 15,000 = 1.13:1
Once we take into account his $13,000 owner’s draw, Bill’s owner’s equity comes to just $15,000, shy of his $17,000 in debt. Remember, an acceptable debt-to-equity ratio is 2:1. Bill is falling short of acceptable; if he had to pay off all his debts quickly, his equity wouldn’t cover it, and he’d need to dip into his company’s income. That makes his business unattractive to potential investors. Unless he changes course, Bill will have trouble getting financing for his business in the future.
Summary Analysis
Bill’s ratios don’t look great, but there’s hope. If he starts liquidating some of his long-term investments now, he can bump his current ratio up to 2:1, meaning he’d be in a healthy position to pay off liabilities with his current assets.
His quick ratio will take more work to improve. A lot of Bill’s assets are tied up in inventory. If he could convert some of that inventory to cash, he could improve his ability to pay of debt quickly in an emergency. He may want to take a look at his inventory, and see what he can liquidate. Maybe he’s got shelves full of books that have been gathering dust for years. If he can sell them off to another bookseller as a lot, maybe he can raise the $10,000 cash to become more financially stable.
Finally, unless he improves his debt-to-equity ratio, Bill’s brother Garth is the only person who will ever invest in his business. The situation could be improved considerably if Bill reduced his $13,000 owner’s draw. Unfortunately, he’s addicted to collecting extremely rare 18th century guides to bookkeeping. Until he can get his bibliophilia under control, his equity will continue to suffer.
Balance sheets can tell you a lot of information about your business, and help you plan strategically to make it more liquid, financially stable, and appealing to investors. But unless you use them in tandem with income statements and cash flow statements, you’re only getting part of the picture. Learn how they work together with our complete guide to financial statements.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.
