A balance sheet provides an idea of a company’s financial position by outlining the total assets it owns, in addition to the amounts it owes to lenders or banks, as well as the amount of owner’s equity. All of this provides valuable information to the banker, who uses the figures as a way of determining whether or not a company qualifies for additional credit or loans.
Here, we’ll take a look at the ins and outs of a balance sheet and how to get started creating your own version of this essential business document.
How does a balance sheet work?
A balance sheet has two sides that must be equal or balance each other out. The thinking behind this is as follows: a company must pay for its assets by borrowing money from lenders or through investors.
So, for example, if Company A takes out a loan for £5,000 from the bank, the assets would increase by £5,000, but the liabilities would also increase by the same amount, effectively balancing the accounts.
The formula of every balance sheet is thus:
Assets = Liabilities + Owner’s Equity
Assets are the physical (tangible) and non-physical (intangible) resources that a company owns and fall under two major categories: current and long-term.
Liabilities are the second part of a balance sheet and refer to what the company owes. Much like assets, they’re classified under two main categories: current and long-term.
Equity is what the owners and stockholders own in the company. This portion of the balance sheet reports how much funding a company has received in exchange for its shares, paid-in-capital and retained earnings. Its value is calculated by subtracting assets of a company from its liabilities, since assets is equal to liabilities plus equity. So, if a company’s total assets are £1,000 and its total liabilities £600, a company’s equity is £400.
The data displayed on the balance sheet provides a business with a better idea of the financial state of the business in the given time period, revealing information about both liquidity and efficiency in the process.
The balance sheet can also provide insight into a business’s leverage, which can illustrate the amount of risk being taken, as well as the returns – such as returns on investment (ROI), for instance.
Though it may seem difficult for those unfamiliar with accounting practices, the balance sheet is easily interpreted, especially those of small businesses that have fewer entries.
While one balance sheet only provides information about the period selected, it can be useful to compare it to balance sheets from previous periods. Combined with the liquidity ratios mentioned above, you can compare your numbers with other businesses to gain an understanding of how a business stands in a particular industry.
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A basic, year-end balance sheet might look like the following:
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