Back to Basics...What's a Balance sheet?
A Balance Sheet is a financial statement which shows what you own in the business and where the funding for that came from #FollowTheMoney. This statement is easily confused with the profit and loss statement which is like a picture of the business, think of the balance sheet as a video it captures more than just one time period. The balance sheet shows how the total amount of your assets and liabilities is distributed among various line items like plant, machinery, land, building, cash, bank balances, investors’ fund, your own fund and bank overdrafts, etc. A Balance Sheet has two sides Assets and Liabilities , which show the total of all the business assets (what you own) is equal to the claims or liabilities (what you owe) against those assets. The report is called Balance sheet because its total on both sides always has to match. It just has to match or it drives accountants nuts. Honestly, the quickest way to get a passionate reply from your accountant is to ask them this question…Why does the balance sheet have to match?
Classified into groups - Divide and understand
Assets and liabilities listed in all Balance Sheets are classified into groups based on their common characteristics like frequency, liquidity and intangibility. Assets are recorded on your right hand side of the Balance Sheet in two main groups, such as, current assets and non-current or fixed assets. Similarly, on your left side of the Balance Sheet, liabilities are grouped under three main headings like current liabilities, non-current liabilities, and Equity. The accurate classification of assets and liabilities are very important to craft accurate balance sheets. So please don’t miscategorize your balance sheet it’s quite painful to fix.
What Are the Main Types of Assets & Liabilities?
Current Assets are based on liquidity which is based on how quickly the business can convert the asset back to cash. The quicker the time period the more liquid the asset. Examples of current asset include cash, bank balance, accounts receivables from customers, stock-in-trade.
Fixed Assets are purchased for long-term use and the assets are not likely to be converted quickly into cash. Some examples of fixed assets are, land, buildings, furniture, and equipment.
Current liabilities are short-term liabilities which are due and payable within one year. Some examples of current liabilities are bills payable, income tax payable, bank overdraft, short term loans.
Non-current liabilities are those liabilities which are due after a year or more. Examples include capital lease, long term loans, due to shareholder balances, etc.
Shareholders Equity is the total investment made by the owners. This includes the money they have invested in the business and any retained earnings from multiple years of operations.
Knowing the above categorizations would provide a great handle on how to read the balance sheet. You might even impress your accountant at year-end.
Remember the Golden Rule:
Assets must always, i repeat always equal liabilities…Assets + Liabilities = Equity (A+L=E). That’s it. That’s the formula, the golden rule that keeps the sanity of Accountants. One rule to rule them all.
Reading a Balance Sheet…like a Boss.
Balance Sheets provide valuable information to the reader because they provide a better deep dive into a business. A seasoned reader would be able to pick up the total assets of the company, the assets that have been financed through debt or equity. Whipping out some fancy financial ratios can really spice things up. Understanding the performance ratios and the liquidity ratios can help you gauge the performance of your business.
Performance Ratios: Net profit ratio (it is calculated by Net Profit, divided by Sales)
Liquidity Ratios: Current ratio (Current Assets divided by Current Liabilities)
Solvency Ratios: Cash flow return on assets (Net Profit plus Non-cash Expenses, divided by Total Assets)
Profitability Ratios: Return on assets (net income, divided by total assets)
Remember Accounting is the business language and learning to read this can only help propel your business forward.
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- Written by: Jag Bath