What Is A Balance Sheet, And How Can It Help Small Businesses?
A balance sheet is a financial statement that contains information about the owner’s equity, assets, and liabilities. It is prepared either annually or for every quarter; and it helps you understand the financial condition of your business.
Small businesses need to keep track of their finances to determine if their business is growing and going strong.
You can think of the balance sheet as a report card or scorecard for your business. It shows the current financial status of your business at different set periods.
Elements of a Balance Sheet
A balance sheet has three elements based on which you determine your financial condition. They are:
- Assets (things owned by the business)
- Liabilities (things owed by the business in the present and future)
- Owner’s Equity (assets + liabilities)
Let us understand what each of these elements means.
Assets
Assets are of three types – current assets, fixed assets, and other assets.
Current assets are the accounts receivable, cash, inventory, and other assets you can convert to cash. These are known as short-term assets.
On the other hand, fixed assets or long-term assets are those which will belong to your business for more than a year. These include vehicles, equipment, land, and buildings.
There are also intangible assets that are not seen physically but hold great value. They can be copyrights, goodwill, trademarks, patents, and franchise rights.
Liabilities
Liabilities are mainly of two types – current liabilities and long-term liabilities.
Current liabilities are those which you need to pay off within a year. They include taxes, credit card payments, accounts payable, debts, and payroll.
On the other hand, long-term liabilities may or may not be paid within one year. They are mortgages, outstanding loans, capital leases, pension liabilities, deferred compensation, deferred income taxes, and deferred revenues.
Owner’s Equity
When you add the assets and liabilities together, it makes up the owner’s equity. That is also called shareholder’s equity. Generally, the owner’s equity shows a positive amount. However, in case the performance of your business is not good, the amount can be negative.
If the owner’s equity shows a negative amount, the company’s profitability will be at risk. Furthermore, it will make it harder for you to get capital from any investor.
Your lenders would only provide you with funds if they are sure you can pay the debt or are in the position to make profits.
Importance of a Balance Sheet for Small Businesses
Small businesses need to update their balance sheets every quarter or year. You need to keep track of your assets, liabilities, and owner’s equity in one place. Without a proper balance sheet, you could fall into major trouble.
Below are some reasons, which will help you understand the importance of a balance sheet for small businesses.
Get Loans from Investors
When you apply for loans, your investors will want to see your financial records. A balance sheet will give them a quick overview of how your business is performing.
Most lenders will ask for your balance sheet to check your creditworthiness and financial condition. It shows them if you are capable of paying the debts at the right time.
If you have a balance sheet that shows your organization in a good position, it becomes easy for you to acquire the loan.
Prevent Potential Issues
A business aims to incur profit from its many business dealings. If you run the business in the right manner, it will show an increase in equity. However, the assets and liabilities will show if your business is not performing well.
For example, if you see your assets section mostly has inventory, it could be a potential risk. If you are unable to sell the inventories quickly, it will slowly become a liability.
Evaluate the Business Return and Risk
The short and long-term assets in your balance sheet show the areas from which you can generate cash. It helps you keep your business afloat. On the other hand, short and long-term debts are obligations for your business.
An ideal balance sheet will have more assets compared to liabilities. That shows a positive aspect in the net worth.
By comparing your short-term assets to short-term liabilities, you can determine if your business is capable of meeting the short-term obligations. If the current liabilities are more than the cash balance, your balance would require outside capital assistance.
The balance sheet will also show if your debt levels are unsustainable. If there are too many debts, you may be unable to pay them and have to file for bankruptcy.
Using your balance sheet, you can prevent such serious long-term problems.
Provide Useful Ratio
Ratios help determine the performance of your business. It is done based on certain elements such as liquidity, solvency, productivity, and profitability.
The financial ratios are essential for understanding if your business will be sustainable in the long run. You can check these financial ratios from your balance sheet.
Summing Up
Preparing a balance sheet is essential for any small business. This balance sheet keeps you and your stakeholder in the loop about the financial condition of the business.
It is also essential to keep the balance sheet updated at all times. And you can use the balance sheet to make important management decisions too! A well-formed balance sheet helps improve your overall business efficiency and financial health. You will have a much better understanding of what to do to keep your business sustainable and profitable.