How to Create and Read a Balance Sheet¹

How to Create and Read a Balance Sheet

A Balance Sheet is a key report used by businesses to assist in measuring the health of their company. The Balance Sheet is a picture of what your business looks like at any moment in time. Just like when someone takes a picture using a camera, the Balance Sheet documents and preserves a “picture” of the business in that moment in time.

There are three things that the Balance Sheet captures:

  1. How much a business owns;
  2. How much a business owes;
  3. How much a business is worth.

Many small business owners do not use the Balance Sheet because they simply do not understand it. They also consider it a report that is just needed by larger companies. Even the smallest of businesses could gain a lot of insight from the Balance Sheet in that it can assist them with measuring the health of their company. If the health of a business is not so great, as determined by the Balance Sheet, a small business owner would then know what specific areas it needs to work on.

How to Create A Balance Sheet

As mentioned earlier, the Balance Sheet tells us three main things; how much a business owns, owes, and is worth. These three things make up the three sections of the Balance Sheet. How much the business owns makes up the “Assets” section, how much the business owes makes up the “Liabilities” section, and, how much the business is worth makes up the “Equity” section.

The reason why this report is called the Balance Sheet is that the three sections need to balance using this formula: Assets = Liabilities + Equity. The total of the assets (or what the business owns) must equal the combined total of the Liabilities (what the business owes) and the Equity (what the business is worth).

For example, if ABC Company has assets of $1,000 and Liabilities of $600 then using the formula you know that the equity must be $400. ($1,000 = $600 + $400).

Here is what the ABC Company Balance Sheet would look like for December 31, 2014:

Assets

Current Assets

$400

Fixed Assets

$600

Total Asset

$1,000

Liabilities

Current Liabilities

$200

Long Term Liabilities

$400

Total Liabilities

$600

Equity

Capital

$100

Retained Earnings

$300

Total Equity

$400

As you can see, the Total Assets ($1,000) equals the Total Liabilities and Total Equity put together ($600 + $400).

How to Read A Balance Sheet

The above example is a basic Balance Sheet at its core. Most Balance Sheets will use this same basic structure but go more in depth in the various sections. There are several insights that you can get about a business by looking at the different sections of its Balance Sheet.

  1. How much a business owns: Using this section, you can tell how much the business has in terms of cash, inventory, equipment, etc. For example, since “cash is king”, knowing how much cash the company has is important so you can tell if it can meet its short term obligations.
  1. How much a business owes: The amount of debt a company has is a major indicator to the health of the company. Even though all debt is still an obligation to pay someone else, some debt could be considered better to have than other types of debt.
  1. How much a business is worth: The equity section can reveal how much funds were provided by investors as well as how much profit in prior periods was kept by the business. This can give you insight into the behavior of the companies’ owners and investors.

Here are the most common terms on the Balance Sheet and what they mean.

  • Current Assets: These are assets that can be converted into cash within one year or less from the date on the Balance Sheet. This would include bank accounts, inventory and accounts receivable.
  • Property, Plant, and Equipment: These are assets that are more long term in nature. As the name indicates, it includes all buildings, land, and major equipment.
  • Intangible Assets: These are assets that are not tangible, such as patents or copyrights.
  • Current Liabilities: These are obligations that are due within a one year period from the date of the Balance Sheet.
  • Long Term Liabilities: These are obligations that are due longer than one year from the date of the Balance Sheet.
  • Paid-In Capital: This is the amount of money investors or owners of the business have paid in exchange for ownership.
  • Retained Earnings: This is the amount of earnings that has been kept by the business since its start until the date of the Balance Sheet less the amount paid out to owners or investors.

By combining the data of the various sections of the Balance Sheet you gain insight into the health of the business. Below are two formulas that many businesses use to evaluate their company.

Quick Ratio

This formula is also referred to as the Liquidity Ratio or Acid Test Ratio. It is simply a way to measure how much of the companies’ assets can be converted to cash if needed to pay short term obligations, such as an upcoming bank loan.

The formula for the Quick Ratio is:

Quick Ratio = Liquid Assets / Current Liabilities

Liquid Assets are those assets that can be more easily converted into cash quickly such as accounts receivables and, of course, cash.

If ABC Company has liquid assets of $500,000 and current liabilities of $300,000 then it’s Quick Ratio is 1.6, sometimes written as 1.6:1 ($500,000 / $300,000 = 1.6). Anything above a 1 indicates that the company should be able to meet short term obligations, whereas, anything less than a 1 indicates that it may not be able to.

Current Ratio

The Current Ratio is very similar to the Quick Ratio in that it measures the company's ability to meet its obligations. However, the Current Ratio includes all assets, not just those that are liquid. This gauge is helpful when comparing your Current Ratio to others in the same industry.

The formula for the Current Ratio is:

Current Ratio = Current Assets / Current Liabilities

If ABC Company has current assets of $600,000 and current liabilities of $300,000 then its Current Ratio is 2, or 2:1. ($600,000 / $300,000 = 2). A larger ratio is much better than a smaller ratio in that it would indicate a higher chance that the company would be able to meet its upcoming obligations.

As you can see, the Balance Sheet is a very useful tool to have when managing and assessing your business. By using this report, you should be able to make better decisions and improve the health of your business. This report is also useful to investors as well as lenders as they will be highly interested in knowing the health of your company.