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What’s the Purpose of a Balance Sheet? | Unlocking Business Growth through Financial Clarity

By June 30, 2023 No Comments

As an entrepreneur, understanding the purpose of a balance sheet is like learning to take a perfect “financial selfie” of your business.

Comprised of three main sections – assets, liabilities, and equity – the balance sheet is a crucial financial statement used to understand your startup’s financial health and stability within a set time period.

With some analysis, you can use the balance sheet to determine if your company has enough resources to meet its obligations, manage or take on debts, and fund future growth.

In other words, the purpose of a balance sheet is to show you what your business owns, what it owes, and what’s left over for you and any other owners. It’s a “selfie” of your business’s financial status.

But just like a selfie doesn’t tell your whole life story, the balance sheet doesn’t do the financial reporting alone. It’s part of a dynamic trio, with the income statement and cash flow statement. Together, they provide essential information that help business owners, shareholders, and potential investors see the full picture.

Now, let’s get into the nitty gritty of the balance sheet: assets, liabilities, and equity.

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Breaking Down the Balance Sheet Snapshot:
Assets, Liabilities, and Equity

Assets: What Your Business Owns

Assets are things your business owns that can be turned into cash. Think of these as your business’s belongings – the more belongings you have, the richer you are.

Here’s how they’re organized:

  • On a balance sheet, assets are listed in order, from the most liquid to the least liquid – otherwise known as the easiest to convert into cash to the hardest.
  • Cash is always listed at the top of a balance sheet because it’s already cash, of course!
  • Assets are further subdivided into short-term and long-term assets on your balance sheet.

Short-Term/Current Assets

Short-term assets, also known as current assets, are resources your business owns that you plan to turn into cash within the next year.

Your short-term assets might include cash, accounts receivable, inventory, short-term investments, cash equivalents (like bonds or stock), and prepaid expenses.

Let’s break down a few of these in order of most liquid to least liquid:

Cash: Cash is king, always at the top because it’s already cash! It includes the cash in your bank account and any petty cash you might keep on hand for small expenses.

Accounts Receivable: This is the money your customers owe you for the products or services you’ve already provided. Think of it as an IOU for your business! For example, if you’re a SaaS company and you’ve provided a subscription service to a customer but haven’t received the payment yet, the amount due is included in your accounts receivable on balance sheets.

Prepaid Expenses: These represent any payments you made in advance for services or products that will be used within the current accounting year. For instance, if you prepaid your website hosting expenses for the next year, this would be considered a prepaid expense.

Long-Term/Non-Current Assets

Long-term assets, also known as non-current assets, are resources your business owns that you will keep – or not turn into cash – for more than a year.

A balance sheet lists long-term assets, such as intangible assets, long-term investments, and fixed assets.

Let’s look at a few examples:

Fixed Assets: Fixed assets are tangible items like buildings, machinery, vehicles, and equipment that your business plans to use for more than a year. Since they contribute to your operations over an extended period and are not for immediate sale, they are considered long-term assets.

For example, equipment is a fixed asset. Here’s how it fits on the balance sheet: the value of your equipment-based assets decreases over time, or depreciates. This depreciation is accounted for on your balance sheet.

For a SaaS company, this could include the cost of servers and computers that are used over a long period of time.

Long-Term Investments: These investments could range from buying stocks or bonds of another company to investing in mutual funds. For example, you might decide to invest in an AI-based startup that aligns with your SaaS company’s strategic goals.

Intangible Assets: As a SaaS company, a significant portion of your assets may be intangible, such as software development costs, patents, or customer relationships. These assets aren’t physical in nature but still hold considerable value for your business.

For instance, if you’ve spent $50,000 on software development, this investment becomes an intangible asset on your balance sheet.

How do you turn intangible assets into cash, you ask? Well, it can be complex. For a SaaS business, the process may include:

  • Licensing or selling intellectual property
  • Leasing or renting software to other companies
  • Using your assets to secure funding from banks or investors.

Depending on the agreement, you may continue to own the underlying asset even after you convert it into cash.

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Liabilities: What Your Business Owes

Just as your business owns things, it also owes things. These are called your liabilities.

The balance sheet lists liabilities in two different categories: current liabilities and non-current liabilities.

  • Current liabilities are what you owe and need to pay within one year.
  • Non-current liabilities are what you owe and will pay over a period that’s longer than one year.

Let’s break them down even further!

Current Liabilities

Current liabilities are the bills your company needs to pay in the next year, listed from what’s due earliest to latest. You can also think of these as your short-term liabilities.

Here are some examples of current liabilities that might be found on your company’s balance sheet:

Accounts Payable: Accounts payable is often the first item listed under “current liabilities” on the balance sheet. It refers to the debt that your business owes to suppliers, vendors, or creditors for any goods or services received on credit. For example, if you’ve used a freelance developer for your company and haven’t paid their invoice yet, that goes into your accounts payable.

Payroll: This shows the salaries and other benefits that you owe to your employees. If you haven’t paid your employees yet for the current month, this would be a payroll liability.

Deferred Revenue: Deferred revenue is money your customers have paid before your company delivers its goods or services. For example, if you’re a SaaS entrepreneur, your customers might pay for their subscription upfront. But since you technically haven’t earned this money yet, this is a liability called deferred revenue.

Short-Term Loan: A short-term loan is money borrowed that typically needs to be paid back within the next year. For example, a SaaS company might get a short-term loan to take advantage of growth opportunities, like expanding their product offerings or investing in marketing campaigns.

Non-Current Liabilities

Non-current liabilities are financial obligations that are not due in the next year.

Here are some examples of non-current liabilities that might be found on your company’s balance sheet:

Long-Term Debt: This could be a business loan you’ve taken to grow your company. For example, if you’ve taken a bank loan with a term of five years, it would be listed as a long-term liability.

Deferred Tax Liabilities: These are income taxes that a company will have to pay in the future but hasn’t paid yet. They occur when there are differences between the taxes calculated for financial reporting and the taxes calculated for tax purposes, often due to tax rules or accounting methods. In simpler terms, it’s a reflection of taxes that are temporarily postponed and will be paid at a later date.

Long-Term Leases: Many companies have rental agreements for equipment or property that last for more than one year. The portion of these payments that is due beyond the next year is reflected as a long-term lease liability.

This section reflects the company’s long-term financial responsibility for using the leased assets.

Equity: What’s Left for the Owners

Last but not least, we’ve got equity on the balance sheet. Equity is not the market value of your business, but it shows the money that has been put into the business, taken out, and the profits made over time.

In simpler terms, Equity = Assets – Liabilities. In other words, equity includes what you own minus what you owe.

This section shows what’s left over for the owners after assets are used to pay off liabilities.

For sole proprietorships, this part of the balance sheet is commonly referred to as “owner’s equity,” while for corporations, it is known as “shareholders’ equity” or “stockholders’ equity.”

Within equity, you’ll find:

Capital: This is the money you, as a company owner, have invested into the business. For instance, if you invested $50,000 from your personal savings to launch your SaaS startup, that amount is added to your capital.

If your business is a partnership, typically the capital accounts of each partner are maintained separately within the balance sheet to track their individual contributions and ownership interests in the business.

Stocks: These include ownership shares, whether they are privately or publicly traded. While SaaS companies are typically structured as private entities, stock options or equity grants may be issued as an incentive to early employees or investors at a corporation.

Retained Earnings: These are the profits your company has earned and chosen to reinvest in the business instead of distributing them as dividends.

For instance, let’s say your business made a profit of $30,000 last year, and you chose to reinvest $20,000 of that back into the business. That amount is your retained earnings.

It’s important to note: equity can decrease when owners withdraw funds for personal use or when corporations pay dividends to shareholders.

Let’s Talk Basic Accounting Equations: For Balance Sheets

The purpose of a balance sheet is shown using one simple equation: Assets = Liabilities + Equity.

This equation separates the balance sheet into two sides. On one side, we have assets – the things your company owns. On the other side, we combine liabilities and equity, representing how these assets are financed.

Here’s the key idea. When you acquire assets for your company, you either borrow money (increasing liabilities) or receive funds (reflected in equity). This equation ensures a balance between what your company owns and how it is financed, giving the balance sheet its name!

Understanding this equation is crucial for interpreting the balance sheet and analyzing your business’s financial standing. Why? It provides a clear framework for assessing the relationship between assets, liabilities, and equity.

Financial Ratios You’ll Need from the Balance Sheet
(and What They Mean)

The balance sheet provides vital information for calculating financial ratios that measure liquidity, leverage, and profitability.

Current Ratio

The current ratio measures your company’s ability to pay its short-term bills. It is calculated by dividing current assets by current liabilities.

Here’s the formula: Current Ratio = Current Assets / Current Liabilities

You can use the current ratio formula to assess your company’s liquidity and short-term financial health, or in other words, to see if you can cover your upcoming expenses.

A ratio above 1 indicates a strong ability to cover expenses, while below 1 may suggest liquidity issues. But, it’s important to note that a very high current ratio might mean that you have underutilized resources.

Debt-to-Equity Ratio

The debt-to-equity ratio measures the proportion of your company’s financing that comes from debt compared to equity, hence the name. It helps you evaluate your company’s leverage and financial risk.

Here’s the formula: Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity

You can use this ratio to understand how much of your company’s financing comes from borrowing versus what you’ve invested.

A high debt-to-equity ratio shows that you rely more on debt financing, which can increase financial risk and interest expense. The ideal debt-to-equity ratio varies across industries, so you should consider industry benchmarks specific to your company when evaluating your ratio.

Return on Assets (ROA) Ratio

The return on assets (ROA) ratio measures how well you’re using your total assets to make money. In other words, it shows the efficiency of your business.

Here’s the formula: Return on Assets = Net Income / Total Assets

A higher ROA indicates higher profitability and better efficiency, while a lower ratio suggests lower profitability or inefficient asset management.

By regularly monitoring these three ratios, you can identify areas of improvement, make informed financing decisions, and compare your company’s performance to others in your industry. In the long run, these benchmarks will guide your financial management, strategic planning, and overall business growth.

How to Create a Balance Sheet

Creating a balance sheet may seem overwhelming at first, but it doesn’t have to be! We’re here to help simplify the process for you.

If you’re using accounting software such as Xero or QuickBooks, you’re in luck! These platforms can automatically generate balance sheets for you based on your accounting records. You’ll just need to ensure your financial transactions are accurately recorded in the software.

By utilizing an accounting software, you can streamline the process of creating balance sheets and gain valuable insights into your company’s financial standing.

Don’t let the idea of creating a balance sheet intimidate you – with the right tools, it’s a straightforward process!

Balance Sheet Example from Our Partners at Xero!

By looking at a balance sheet, you can quickly see if a company is doing well or not. It shows you what the company owns and what it owes.

In the example balance sheet from Xero, you can see that the assets of the company have increased significantly year over year, primarily due to a surge in cash and cash equivalents. However, the liabilities also show an increase, with a substantial rise in sales tax liability and accounts payable.

While these are just some of the immediate surface level takeaways, they provide an entrepreneur with a great starting point for a more in-depth conversation around the year-over-year performance of their company with an accountant or financial advisor.

– Ben Andres, Implementation Partner Consultant for Xero

Balance Sheet, Next Steps

Got more balance sheet specific questions? Tune into our video below with Acuity Co-Founder Matthew May, and check out the FAQ section.

And if you’re interested in learning more about tips and tricks for managing your business’s financial health, book a free consultation with our team. We’re always here to support entrepreneurs like you in your financial journey.

Frequently Asked Questions

You asked, and we answered. To recap, here’s a quick rundown of everything balance sheet:

What's the difference between an income statement and a balance sheet?

We get this question all the time – balance sheet vs. income statement…what’s the difference? While a balance sheet provides a snapshot of your financial health at a specific moment, an income statement is more like a financial scorecard. It shows how your business performed over a given period – a month, a quarter, or a year.

How do you calculate net income from a balance sheet?

You don’t calculate net income from a balance sheet. Net income comes from your income statement and is then transferred to the equity section of your balance sheet.

What is goodwill on a balance sheet?

Goodwill is an intangible asset that arises when a business is acquired for more than the value of its tangible assets and liabilities. It can include things like customer relationships, brand reputation, and intellectual property.

How can you find retained earnings on a balance sheet?

Retained earnings are listed under the equity section of your balance sheet. For more information on balance sheet retained earnings, scroll up to our section on equity!

What are retained earnings on a balance sheet?

Retained earnings show the total amount of net income that your business has retained over the years.

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