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What is a balance sheet and why is it important?

August 25, 2022As a business owner, striking balance can be tricky — whether it’s work-home life, revenue-expenditure or what you own and what you owe. Just to name a few examples.But a balance sheet (or a “statement of financial position”) is designed to make things simple. A balance sheet is a financial statement that can help you understand how well your business is doing by giving you a snapshot of your company’s financial position.Want to get to grips with balance sheets? This article will give you a clear definition of what a balance sheet is, how balance sheets work and a balance sheet example — read on.

What is a balance sheet?

A balance sheet lists exactly what your business owns and what it owes, as well as the amount invested by shareholders. That way, investors, stakeholders or regulators can check in on important metrics, such as the debt-to-equity ratio, and based on their findings can offer business advice, as well as make informed decisions on whether to invest in the future.If you want to perform a financial health check on your business, a balance sheet will give you the insight you need.A balance sheet helps you understand how your business is performing today, how well it’s performed in the past, and how well it’s likely to perform in the future.As well as keeping you up to date and away from financial problems, it’s a great tool for attracting investors’ attention.From how you transform your assets into revenue to how you handle debt, your company's balance sheet allows you to present an overview of your accounting metrics, all on one nifty page.

Balance sheet: key definitions

Your balance sheet outlines your business’s net worth by recording these three accounts:

1. Net assets — what you own
2. Total liabilities — what is owed to outside parties
3. Shareholder’s equity or owner’s equity net worth — the total value of assets, minus any liabilities

The clue is in its name: a balance sheet must always balance. That’s why this balance sheet equation is handy to remember: The reverse works, too, if you want to work out your total assets (assets = liabilities + equity).Before we dive into the maths, let’s take a closer look at the terminology.

Assets

An asset is anything (of value) that your company owns. Your company’s total assets are a combination of the following:

Fixed assets — otherwise known as non-current assets or long-term assets, are assets that are not expected to be used or sold within the financial yearCurrent assets — assets that can easily be turned into cash or cash equivalents in one year or lessIntangible assets — non-physical assets that are expected to yield results in the future

You’ll list your current assets on your balance sheet first. They include:

Accounts receivable — money that customers owe youInventory — items that you sell to earn a profitPrepaid expenses — e.g. if you’ve paid for rent or insurance in advance

Examples of fixed assets include:

Property, plant and equipment (PP&E)Buildings and landLong-term investments

Finally, intangible assets include the following:

Your brand name and goodwillIntellectual property, such as patents, designs, copyright and trade marks

On your balance sheet, your assets will be organised from most liquid to least liquid (easiest to turn into cash to the not-so-easy). Equally, liabilities accounts are organised from short to long-term borrowings.

Liabilities: balance sheet obligations

Liabilities are also subdivided into two categories: short-term liabilities and long-term liabilities.Otherwise known as non-current liabilities, long-term liabilities include things that aren’t due to be repaid within the year. Bonds payable, long-term debts and interest are all examples of long-term liabilities.However, short-term liabilities, or current liabilities, must be paid sooner, e.g. money owed to HMRC, and accounts payable (e.g. salaries, interests on loans).In other words, current liabilities include anything that’s payable within a year. They tend to include:

InterestWagesTaxesUtilitiesAccounts payable (money you owe, bought on credit)

In a balance sheet, you’ll record your liabilities next to your assets.

Equity, explained

Equity is what’s left when you take away what you owe from what you own.Similar to if you’ve got a mortgage, the equity is the proportion of what you own outright. For example, if you own a £400,000 home, which has a £150,000 mortgage on it, then you have £250,000 in equity.On a balance sheet, equity is calculated by subtracting your liabilities from your total assets.

Balance sheet example

Below, you’ll find a simple example of what a balance sheet looks like:

Who needs a balance sheet?

Only publicly-trading companies are required to have balance sheets. That doesn’t mean others can’t have them, though.If you’re a sole trader or a small business owner, you might be intrigued to find out your financial status. Even though you aren’t legally required to have a balance sheet for tax or regulatory purposes, it’s useful to have a clear overview of the money you have.The main user of the balance sheet will be the small business owner, who will use it to get to grips with the overall position of the business and how well it’s performing.Executives, investors, analysts and regulators also like to have a look at balance sheets. They’ll use this, alongside your income statement and cash flow statement, to check your current financial health.

How often do I need to prepare a balance sheet?

Balance sheets can be prepared as regularly as you like: monthly, quarterly or annually. The more frequently they are prepared, the more up-to-date the business owner is on the financial position of their business. It’s always practical to have one.

The difference between balance sheets and income statements

Meanwhile, an income statement looks at what you’ve bought or spent over a certain length of time. They’re useful for budgeting, but they don’t take into account longer-term liabilities.

Get started with Ember

Balance sheets can be intimidating if you’re not familiar with accounting.Want to make smart decisions about your business? Save time and hassle: get accounting help with Ember. We’re here to give you the tools you need. No complexity, no jargon. Simply book a demo with a member of our team to see how we can help your business thrive.