Henry Ford said: “the two most important things in any company do not appear on its balance sheet: its reputation and its people.” Nonetheless, a balance sheet is an important financial statement for every business. Understanding what goes into a balance sheet and what it can tell you about your business is essential.
1. What a balance sheet is all about
A balance sheet is a statement of a business’s assets, liabilities, and owner’s equity as of any given date. Typically, a balance sheet is prepared at the end of set periods (e.g., every quarter; annually).
A balance sheet is comprised of two columns. The column on the left lists the assets of the company. The column on the right lists the liabilities and the owners’ equity. The total of liabilities and the owners’ equity equals the assets. To take the simplest example, say a company starts up by an owner who contributes $1,000 cash. The company has assets of $1,000, no liabilities, and owner’s equity (the owner’s contribution to the business) of $1,000, so both columns match up.
2. Debt ratio
The balance sheet presents a glimpse into how the company is doing financially. One of the key indices is the debt ratio, which is the ratio derived by comparing total debts to total assets. More precisely, divide total liabilities by total assets to obtain a percentage. For example, if a company has assets of $100,000 and debts of $55,000, the debt ratio is 55% ($55,000 ÷ $100,000).
If your assets can cover your debts, that’s fine, but it’s not advisable to have too much debt as compared with company assets. The larger the percentage (the debt ratio), the more the company is leveraged. This could present problems when a company is too heavily leveraged. The acceptable debt ratio varies according to industry.
3. Owner’s equity
In broad terms, owner’s equity is essentially what would be left for owners from company assets after paying off all liabilities. It’s what you have invested in the business.
- For a sole proprietorship, equity represents the owner’s investment in the business (cash and property put into the business), minus any withdrawals (e.g., a monthly draw for personal living expenses).
- For a corporation, owner’s equity is called shareholder equity. In general, it represents the value of corporate stock and retained earnings (undistributed amounts). There are some other adjustments that can be made.
Comparing owner’s equity from one period to the next shows you how your investment is doing. If owner’s equity declines, you need to review what’s going on and make changes. Maybe you need to pay off debts and reduce liabilities reported in the balance sheet. If owner’s equity is increasing, that’s a good thing. Keep it up!
4. Who looks at the balance sheet
As previously stated, the balance sheet is an important clue to a business owner about how his or her company is doing. But owners aren’t the only people looking at the balance sheet:
- Lenders typically look at this financial statement. For example, when applying for an SBA 7(a) loan over $350,000, a balance sheet is required.
- Investors and, when you put the company up for sale, buyers also look at a balance sheet to help assess the company’s financial position.
5. The balance sheet and tax reporting
For federal income tax purposes, only C corporations are required to complete a balance sheet as part of their annual return. This balance sheet compares items at the beginning of the year with items at the end of the year. The IRS wants to see that the balance sheet included with Form 1120 agrees with the corporation’s books and records. Small corporations—those with total receipts and total assets less than $250,000 at the end of the year—are not required to complete the balance sheet in the tax return.
Final thought
You don’t have to be an accountant or great with numbers to create a balance sheet for your business. In fact, your accounting product can prepare one for you automatically based on the information you provide. Or you can use a template, such as one available from the SCORE, to create your own balance sheet.
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