The Balance Sheet
The balance sheet is a financial snapshot of what your business owns (its'
assets) and what it owes (its' liabilities) at a particular point in time e.g. year end.
The difference between the assets and liabilities represents the owner’s equity or
financial investment in the company. This is the basic accounting equation used
in the preparation of the balance sheet. Assets = Liabilities + Owner’s Equity
The format of the balance sheet is standardized with assets on the left and
liabilities and owner’s equity on the right so that when it is prepared properly, it is
"balanced". In other words, the total worth of your business, which is determined
by your asset total, is equivalent to the money you or your shareholders have
directly invested (equity) plus the amount of money that has been borrowed to
put into the business (liabilities).
The balance sheet provides a wealth of information useful to business owners,
managers, creditors, prospective investors, tax departments and the general
public in some instances. From the balance sheet you can determine:
• The solvency or insolvency of the company in the short term.
• Future financial commitments.
• Owner’s and shareholder’s investment in the company.
• Changes or trends in the company’s financial condition if compared over
• Extent of creditor involvement in the company.
Here is how a typical balance sheet would be set up:
TOTAL ASSETS ………………$_______ TOTAL LIABILITIES…………. $______
Balance at beginning of year
Income for the year
Less owner’s drawings
Total Owner’s Equity
TOTAL LIABILITIES & OWNER’S
EQUITY………………………… $______ Assets Current Assets
These are any items, which could be converted into cash in the normal course of
business within one year. Examples are cash, receivables, supplies, prepaid
expenses, etc. These should all be itemized separately on the balance sheet. Fixed Assets
These are items which have an expected life measured in years. They cannot be
liquidated as quickly as a current asset and most of them are depreciated at set
rates over the estimated life of the asset. Examples of fixed assets include
building, furniture, automobiles, land, etc.
Liabilities Current Liabilities
These are liabilities that you must meet within the next year, for example trade
supplier credit or small operating loans. Long-term Liabilities
These are financial obligations that you are committed to for a period that
exceeds one year. These could include mortgages or large equipment
purchases. Owners Equity Capital
This represents the capital investment of the owner and/or shareholders. Balance, beginning
This is the amount of cash that has been invested in the company at the start of
the period. Income for the Year
The income for the period is the net income identified on the income statement. Less Owner’s Drawings
Drawings come directly out of the equity of the business. They are not treated as
wages. How To Analyze A Balance Sheet
Now that you have created a balance sheet for your business, there are some
easy calculations that you can perform that will give you a better understanding
of your company. Using data from your balance sheet, you can calculate liquidity
and leverage ratios.
These financial ratios turn the raw financial data from the balance sheet into
information that will help you manage your business and make knowledgeable
decisions. A ratio shows the relationship between two numbers. It is defined as
the relative size of two quantities expressed as the quotient of one divided by the
other. Financial ratio analysis is important because it is one method loan officers
use to evaluate the creditworthiness of potential borrowers. Ratio analysis is a
tool to uncover trends in a business as well as allow the comparison between
one business and another. In the following section, four financial ratios that can
be computed from a balance sheet are examined:
Debt/Worth Ratio Current Ratio
The current ratio (or liquidity ratio) is a measure of financial strength. The number
of times current assets exceed current liabilities is a valuable expression of a
business' solvency. Here is the formula to compute the current ratio: Current ratio = Current Assets / Current Liabilities
The current ratio answers the question, "Does my business have enough current
assets to meet the payment schedule of current liabilities with a margin of
safety?" A rule-of-thumb puts a strong current ratio at two. Of course, the
adequacy of a current ratio will depend on the nature of the small business and
the character of the current assets and current liabilities. While there is usually
little doubt about debts that are due, there can be considerable doubt about the
quality of accounts receivable or the cash value of inventory.
A current ratio can be improved by either increasing current assets or
decreasing current liabilities. This can take the form of the following:
• Paying down debt.
• Acquiring a loan (payable in more than 1 year's time.)
• Selling a fixed asset.
• Putting profits back into the business.
However, a high current ratio may mean that cash is not being utilized in an
optimal way. That is, the cash might better be invested in equipment. Quick Ratio
The quick ratio is also called the "acid test" ratio. It is a measure of a
company's liquidity. The quick ratio looks only at a company's most liquid
assets and divides them by current liabilities. Here is the formula for the quick
Quick ratio = current assets-inventory / current liabilities
The assets considered to be "quick" assets are cash, stocks and bonds, and
accounts receivable (all of the current assets on the balance sheet except
inventory). The quick ratio is an acid test of whether or not a business can
meet its obligations if adverse conditions occur. Generally, quick ratios
between .50 and 1 are considered satisfactory — as long as the collection of
receivables is not expected to slow. Working Capital
Working capital should always be a positive number. It is used by lenders to
evaluate a company's ability to weather hard times. Often, loan agreements
specify a level of working capital that the borrower must maintain. The current
ratio, quick ratio and working capital are all measures of a company's liquidity.
In general, the higher these ratios are, the better for the business and the
higher degree of liquidity. Working Capital = Total Current Assets - Total Current Liabilities Debt/Worth Ratio
The debt/worth ratio (or leverage ratio) is an indicator of a business' solvency.
It is a measure of how dependent a company is on debt financing (or
borrowings) as compared to owner's equity. It shows how much of a business
is owned and how much is owed. The debt/worth ratio is computed as follows: Debt / Worth ratio = Total Liabilities / Owner’s Equity
For More Information: Internet:
- The Balance Sheet
- Current Assets
- Fixed Assets
- Current Liabilities
- Long-term Liabilities
- Balance, beginning
- Income for the Year
- Current Ratio
- Current ratio = Current Assets / Current Liabilities
- Quick ratio = current assets-inventory / current liabilities
- Working Capital = Total Current Assets - Total Current Liabilities