What is a balance sheet, exactly?
A balance sheet is also called a statement of financial position. It tells you how much you owe others, and how much others owe you. It also lets you see what you and others have invested in the company.
When you use financial ratios to analyze it, a balance sheet can tell you whether your business is built on solid foundations—able to pay its bills in a pinch; or skating on thin ice—deeper in debt than it can recover from.
If you’re brand new to all this, check out our guide to balance sheets. Once you’re up to speed, come back here to learn how to read them.
Balance sheets and other financial statements
Along with an income statement and a cash flow statement, a balance sheet is one of three essential financial statements that let you measure your financial health.
Here’s what each member of the trio contributes:
- Income statements tell you how much you’ve spent and how much you’ve made over a certain period
- Cash flow statements tell you how much cash you have available within a certain period
- Balance sheets show what you owe, what you’re owed, and what you have invested
For a full rundown on how these work together, see our guide to financial statements.
Anatomy of a balance sheet
Your garden variety balance sheet is split into three sections: Assets, liabilities, and equity. Here’s an example:
Assets are good—they’re anything valuable that you own. Cash is an asset, but so are inventory, equipment, securities (also called cash equivalents), and accounts receivable (money others owe you). There are two types of assets: Current assets, and long-term assets. We’ll cover both shortly.
Liabilities are less good—they’re money you owe. Think debt from loans, invoices you need to pay, wages you owe employees—anything that puts a dent in your wallet. Current liabilities and long-term liabilities are the two flavors you have to choose from. More on those in a minute.
Equity is money your business has to work with. That means retained earnings, as well as money from investors and shareholders. If you spent $1,000 to get your dropshipping business off the ground, that’s owners’ equity. If you’ve saved $300,000 income from your custom bobblehead service, that’s also equity. Company stock and bonds are both equity as well.
The accounting equation
The accounting equation tells us how assets, liabilities, and equity are related:
Assets = Liabilities + Equity
So if your total liabilities come out to $100,000, and your total equity comes to $200,000, you have $100,000 in assets.
It’s important to know this equation, because it’s the foundation of how your balance sheet works. If the equation doesn’t add up—if your assets are worth more or less than your liabilities or equity—then something is off.
Field guide to balance sheet line items
We’ve talked a bit about the different sections of your balance sheet. If you checked out the example above, you’ll see that each of those sections is broken down into individual line items. Those line items add up to form your total assets, liabilities, and equity, respectively.
The line items on your balance sheet will depend on your business. For instance, if you’re a sole proprietorship, you don’t issue stock—so there’s no line item for company stock. And if you run a dropshipping business, you don’t have inventory—so there’s no line item for inventory.
This mini field guide covers the most common line items—the ones you’re most likely to see on your balance sheet. Some are self-explanatory, some aren’t. Reading through this guide will give you a sense of the breadth of information a balance sheet can contain. Spoiler warning: It’s a lot.
Current assets
Also called short-term assets, current assets include both cash and cash equivalents that can quickly become cash. Meaning, they’re easy to liquidate. That’s important, because in financial emergencies, companies need assets they can quickly convert into cash.
Cash in bank accounts: Cold hard cash, stored in your company’s bank accounts. The most liquid asset of all.
Accounts receivable: Money you’re owed, such as invoices you’ve sent clients.
Short-term investments: Cash equivalents you can easily liquidate, like Treasury bills or certificates of deposit. These are investments you plan to sell off within a year.
Raw materials: Supplies used to manufacture your products, or products that are still in production.
Inventory: Your store of products for sale, whether you’ve produced them yourself or bought them from a supplier.
Long-term assets
Also called non-current assets, long-term assets are harder to liquidate than current assets. That means you’ll be holding on to them longer, and less likely to use them in case you need to pay off debt.
Long-term investments: Financial products typically held for more than a year, including stocks and bonds.
Real estate: Land or buildings that your business plans to hold for more than a year.
Equipment: Tools or facilities used for business operations.
Marketable securities: Securities your company has available to sell. This includes common stock, preferred stock, and bonds.
Intangible assets: Hard to quantify assets, such as intellectual property, including trademarks and patents, or a client list.
Current liabilities
Also called short-term liabilities, current liabilities are ones you plan to pay off within a year’s time.
Accounts Payable: Money you owe, such as unpaid invoices from suppliers and contractors.
Short-term loan debt: Any loan that’s due to be paid off within one year, such as small, short-term loans or cash advances.
Credit card debt: Debt you’ve incurred on your company credit card.
Interest payments: Payments you’re required to pay on a loan, without necessarily paying down the principal.
Wages owed: Any outstanding wages due to employees.
Taxes owed: Tax debt that needs to be paid off within a year.
Long-term liabilities
Also known as non-current liabilities, long-term liabilities will take longer than a year to pay off.
Long term loans: Large loans that you don’t plan on paying off any time soon.
Line of credit debt: Debt you’ve accrued on a line of credit, and don’t intend to pay off within a year.
Equity
The money you’ve put into a business is equity. That includes initial investments you or other backers have made, and earnings you’ve retained in order to reinvest in the company.
Equity can also be parts of the business, such as shares, that you’re able to liquidate by selling. Stock held by shareholders is also listed, because it contributes to your company’s book value.
Initial Capital: The funds invested into a business when it started.
Retained earnings: Income you’ve set aside for business purposes, rather than taking out as an owner’s draw.
Business owner’s draw: Money taken out of equity to pay the business owner or owners. Written as a negative value on the balance sheet.
Shareholders’ equity: The book value of stock held by shareholders.
Preferred stock: Stock whose holders don’t have voting rights in your company, but who get payment priority—meaning, they’re paid dividends before owners of common stock are.
Common stock: Stock whose holders are able to vote for your company’s board of directors. Pays dividends after preferred stock.
How to analyze balance sheets with financial ratios
So, your balance sheet is looking great. Lots of assets and equity, not much liability. How do you explain that to the people who matter—like potential lenders and investors?
You can think of financial ratios as compressed bits of information that describe your company’s financial health. The relationships between different numbers on your balance sheet—like your total equity in comparison to your total liabilities—describe how your company is performing. Tracking those ratios over time can tell you how your business is improving at some things, or where there’s space for it to get better.
You could fill a massive, leather bound book with all the esoteric ratios that financial advisors use to crunch a company’s numbers. For the sake of space and sanity, we’ll cover the three most important financial ratios: The current ratio, the debt-to-equity ratio, and the quick ratio.
The current ratio
Can your company pay its debts? The current ratio measures the liquidity of your company—how much of it can be converted to cash, and used to pay down liabilities. The higher the ratio, the better your financial health in terms of liquidity.
The ratio for finding your current ratio looks like this:
Current Ratio = Current Assets / Current Liabilities
You should aim to maintain a current ratio of 2:1 or higher. Meaning, your company holds twice as much value in assets as it does in liabilities. If you had to, you could pay off all the money you owe two times over.
Once you drop below a current ratio of 2:1, your liquidity isn’t looking so good. And if you dip below 1:1, you’re entering hot water. That means you don’t have enough liquidity to pay off your debts.
You can improve your current ratio by either increasing your assets or decreasing your liabilities.
The quick ratio
Also called the acid test ratio, the quick ratio describes how capable your business is of paying off all its short-term liabilities with cash and near-cash assets. In this case, you don’t include assets like real estate or other long-term investments. You also don’t include current assets that are harder to liquidate, like inventory. The focus is on assets you can easily liquidate.
Here’s how you get the quick ratio:
Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
If your ratio is 1:1 or better, you’re sitting pretty. That means you’ve got enough quick-to-liquidate assets to cover all your short term liabilities in a pinch.
The debt-to-equity ratio
Similar to the current ratio and quick ratio, the debt-to-equity ratio measures your company’s relationship to debt. Only, in this case, the key value is your total equity.
This ratio tells you how much your company depends upon equity to keep running versus how much it depends on outside lenders. It’s calculated like this:
Debt to Equity Ratio = Total Outside Liabilities / Owner or Shareholders’ Equity
Generally speaking, a 2:1 ratio is considered acceptable. If the ratio gets bigger, you start running into trouble. It means your business relies heavily on debt to keep running, which turns off investors. The higher the ratio, the higher the chance that, in the event you need to pay off your debt, you’ll use up all your earnings and cash flows—and investors will end up empty-handed.
Examples of balance sheet analysis
We’ll do a quick, simple analysis of two balance sheets, so you can get a good idea of how to put financial ratios into play and measure your company’s performance
Example balance sheet analysis: Annie’s Pottery Palace
Summary:
Annie’s Pottery Palace, a large pottery studio, holds a lot of its current assets in the form of equipment—wheels and kilns for making pottery. Accounts receivable play a relatively minor role.
Liabilities are few—a small loan to pay off within the year, some wages owed to employees, and a couple thousand dollars to pay suppliers.
Annie’s is a single-member LLC—there are no shareholders, so her equity includes only her initial investment, retained earnings, and Annie’s draw($4,000).
Ratio analysis:
Current ratio: 22,000 / 7,000 = 3.14:1
Annie’s current ratio is very healthy. If necessary, her current assets could pay off her current liabilities more than three times over.
Quick ratio: 6,000 / 7,000 = 0.85:1
Her quick ratio isn’t looking so hot, though. Annie’s currently sitting just below 1:1, meaning she wouldn’t be able to quickly pay off debt.
Debt-to-equity ratio: 7,000 / 15,000 = 0.46:1
Annie’s debt-to-equity looks good. She’s got more than twice as much owner’s equity than she does outside liabilities, meaning she’s able to easily pay off all her external debt.
Final analysis:
Annie is able to cover all of her liabilities comfortably—until we take her equipment assets out of the picture. Most of her assets are sunk in equipment, rather than quick-to-cash assets. With this in mind, she might aim to grow her easily liquidated assets by keeping more cash on hand in the business checking account.
That being said, her owner’s equity is more than capable of covering her debt, so this problem shouldn’t be difficult to fix. It would be wise for Annie to take care of it before applying for loans or bringing on investors.
Example balance sheet analysis: Bill’s Book Barn LTD.
Summary:
A lot of Bill’s assets are tied up in inventory—his large collection of books. The rest mostly consists of long-term investments and intangible assets. (Bill’s Book Barn is famous among collectors of rare fly-tying manuals; a business consultant valued his list of dedicated returning customers at $10,000.)
He doesn’t have a lot of liabilities compared to his assets, and all of them are short-term liabilities. Meaning, he’ll need to pay off that $17,000 within a year.
Finally, since Bill is incorporated, he has issued shares of his business to his brother Garth. Currently, Garth holds a $12,000 share in the business, a little shy of half its total equity.
Ratio analysis
Current ratio: 30,000 / 17,000 = 1.76:1
Since long-term investments and intangible assets are tough to liquidate, they’re not included in current assets—meaning Bill has $30,000 in assets he can more or less easily use to cover his liabilities. His ratio of 1.76:1 isn’t great—it doesn’t leave much wiggle room if he wants to pay off his liabilities. But it isn’t terrible, either—he’s just shy of a healthy 2:1 ratio.
Quick ratio: 7,000 / 17,000 = 0.41:1
Bill’s quick ratio is pretty dire—he’s well short of paying off his liabilities with cash and cash equivalents, leaving him in a bind if he needs to take care of that debt ASAP.
Debt-to-equity ratio: 17,000 / 15,000 = 1.13:1
Once we take into account his $13,000 owner’s draw, Bill’s owner’s equity comes to just $15,000, shy of his $17,000 in debt. Remember, an acceptable debt-to-equity ratio is 2:1. Bill is falling short of acceptable; if he had to pay off all his debts quickly, his equity wouldn’t cover it, and he’d need to dip into his company’s income. That makes his business unattractive to potential investors. Unless he changes course, Bill will have trouble getting financing for his business in the future.
Summary Analysis
Bill’s ratios don’t look great, but there’s hope. If he starts liquidating some of his long-term investments now, he can bump his current ratio up to 2:1, meaning he’d be in a healthy position to pay off liabilities with his current assets.
His quick ratio will take more work to improve. A lot of Bill’s assets are tied up in inventory. If he could convert some of that inventory to cash, he could improve his ability to pay of debt quickly in an emergency. He may want to take a look at his inventory, and see what he can liquidate. Maybe he’s got shelves full of books that have been gathering dust for years. If he can sell them off to another bookseller as a lot, maybe he can raise the $10,000 cash to become more financially stable.
Finally, unless he improves his debt-to-equity ratio, Bill’s brother Garth is the only person who will ever invest in his business. The situation could be improved considerably if Bill reduced his $13,000 owner’s draw. Unfortunately, he’s addicted to collecting extremely rare 18th century guides to bookkeeping. Until he can get his bibliophilia under control, his equity will continue to suffer.
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Balance sheets can tell you a lot of information about your business, and help you plan strategically to make it more liquid, financially stable, and appealing to investors. But unless you use them in tandem with income statements and cash flow statements, you’re only getting part of the picture. Learn how they work together with our complete guide to financial statements.
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