How to read a balance sheet

Trying to make sense of your startup’s balance sheet? Look no further. In this article, we will examine the components of the balance sheet, its structure, and how to use it effectively.

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This article is part two of our three-part series, which breaks down the three financial reports most commonly encountered by startups and small businesses. Catch up with part one here, which breaks down the profit & loss statement, and stay tuned for part three, in which we’ll cover the cash flow statement. 

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What is the balance sheet?

The balance sheet provides a snapshot of your company’s finances at a specific point in time by comparing what you own (assets) to what you owe (liabilities), and detailing the value of the shareholders’ investment (equity). Simply put, it balances money raised with money spent.

Sometimes referred to as a statement of financial position, balance sheets are typically delivered on a monthly basis alongside the profit & loss statement and the cash flow statement. To better understand trends over time, compare your current balance sheet against those from previous periods.

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Why is the balance sheet important?

The balance sheet is used to conduct financial analysis of your business, evaluate capital structure and calculate financial ratios. For startups, balance sheets are commonly used to calculate the debt to equity ratio, which is used to compute rates of return of shareholders’ investments. 

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Common components of the balance sheet 

The balance sheet details a company’s assets, liabilities and equity:

  - Assets

• Current assets (e.g. Cash & Equivalents, Prepaid expenses)
• Fixed assets (e.g. Computer Equipment, Office furniture, Equipment)
• Non-current assets (e.g. Deposits, Patents)

  - Liabilities

• Current liabilities (e.g. Accounts payable, Accruals)
• Long-term liabilities (e.g. Long-term loans, Deferred revenue)

  - Equity

• Retained earnings
• Current earnings
• Common stock
• Preferred stock

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How is the balance sheet different from the profit & loss statement and cash flow statement? 

If a balance sheet provides a snapshot of a company’s assets, liabilities, and equity in a given period of time, what information does a profit & loss statement and cash flow statement provide? 

• A profit & loss statement (P&L), or income statement, summarizes the revenues, costs, and expenses from a specified time period.
• A cash flow statement shows incoming and outgoing cash movements on (typically) a monthly basis, in much more detail than a P&L statement.

In the first installment of this three-part series about startup financial statements, we addressed the P&L statement in detail. The next installment will break down the cash flow statement, so stay tuned. 

How to read a balance sheet

When you review your balance sheet, you’ll see three main categories - Assets, Liabilities and Equity - and their respective subcategories. As with all financial reports, depending on the type of business you operate and your financing situation, your balance sheet may only reflect some of the subcategories we detail below.

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Assets

First and foremost, your balance sheet breaks down all of your company’s assets, defined as something your company owns that has value. Assets include cash and items such as computer equipment, furniture, and leasehold improvements. They can also be intangible, such as patents, intellectual property, and goodwill.

Every company, including your startup, should establish a capitalization policy with a threshold amount for expensing vs capitalizing. For example, capitalize assets worth more than $2,500, and expense assets worth less than $2,500 as operating expenses.

In this section of the balance sheet, accounts are listed from top to bottom in order of their liquidity. Current assets are those that can be converted to cash in one year or less, while fixed assets and long-term assets are those your company plans to hold for more than one year.

Current assets

Current assets include all company assets that are expected to be converted to cash within one year. Your startup’s current assets encompass several categories. The most liquid of all assets are cash and cash equivalents. Cash equivalents include assets that mature in under three months or assets that the company can liquidate on short notice. 

Assets which may be classified as current assets include:

• Accounts receivable, which includes the balance of all sales revenue on credit (net any allowances for uncollectible balances). 
• Inventory, including amounts for raw materials, work-in-progress goods, and finished goods. This account is decremented when sales are made, and the resulting offset account is Costs of Goods Sold (or COGS) in the P&L statement.
• Marketable securities, including common stock and Treasury bills, are also current assets, as they can easily be purchased, sold, and traded. 
• Prepaid expenses. For example, consider a payment made in January for a tradeshow that won’t occur until May. In January, it would be recorded as a prepaid expense, and when the expense is actually incurred in May, it would be reclassified to a tradeshow expense.

Fixed assets

Also referred to as capital assets or Plant, Property, and Equipment (PP&E), fixed assets are tangible items, such as computers, office furniture, or equipment, that your company plans to use for more than one year.

Physical assets categorized as fixed or long-term are depreciable, meaning the value of these assets are adjusted over time based on how much of its value remains. Some intangible assets including patents, copyrights and software are also subject to depreciation. While this is a more technical aspect of business accounting, it’s important to call this out as a company’s profits can be negatively impacted if depreciation is not taken into account.

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Non-current assets

Non-current assets, also described as long-term assets, include long-term investments your company plans to hold for at least one year. Intangible assets, such as patents, licenses, and trademarks, are also included (when relevant).

As you may have gathered from this section, correctly classifying your business assets can be challenging and confusing for someone without an accounting background. Enlisting the support of finance experts is advisable to make sure your business’ financial statements are in order.

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Interested to know how Zeni works with startup founders and small business owners to deliver up-to-the-minute financial insights? Sign up for a demo today.

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Liabilities

The money owed by your startup to outside parties are your liabilities. They’re divided into two categories: Current and Long-term.

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Current liabilities

Current liabilities are those due within one year and are listed in order of their due dates. These include:

• Accounts payable
• Accrued expenses
• Bank indebtedness
• Current portion of long-term debt
• Customer prepayments
• Deferred revenue
• Interest payable
• Payroll clearing
• Unearned revenue
• Accrued payroll

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Long-term liabilities

Liabilities due at any point in time after one year are considered long-term. Long-term liabilities include long-term debt, long term portion of deferred revenue, and notes payable due to convert in more than 12 months.  

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Equity

The third and final section of a balance sheet represents shareholders’ equity, or owners' equity, which is the money attributable to a business’ owners, meaning its shareholders. It’s also referred to as net assets. The shareholders’ equity section includes:

• Retained earnings
• Current earnings
• Common stock
• Preferred stock

Retained earnings

The retained earnings line item shows how much of a company’s earnings are ready for reinvestment into the business or debt repayment. Retained earnings are represented as profits or losses.

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Current earnings

This figure represents the current year’s net income. Current earnings are also expressed as the difference between all revenues and expenses.

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Common stock

The corresponding figure on the balance sheet represents what the common stock sold for based on its par value, which is the stock value stated in the corporate charter at the time a corporation is created. The par value is typically set at less than one cent per share. Importantly, this figure does not reflect actual market value.

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Preferred stock

Preferred stock is a type of equity security issued by a company for the purpose of raising money; the line-item on the balance sheet shows the total amount received from issuing preferred stock. 

Together, common stock and preferred stock represent ownership in the entity. Main difference between the two is that common stockholders have voting rights/decision making capacity, while preferred stockholders do not have voting rights; however, common stockholders have a higher order of priority over income of the company, and are paid dividends and repayment of capital ahead of common stockholders.

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Does the balance sheet always balance out?

Liabilities + Shareholders’ Equity = Assets

Yes. The sum of your company’s liabilities and shareholders’ equity should always equal your company’s total assets. 

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What is the balance sheet used for?

Now that we’ve covered what a balance sheet is made up of, we can look into what it’s used for. It can be interpreted in different ways, based on what the intention is of the person who is reading it. 

A balance sheet can be used to analyze your company’s financial position and calculate financial ratios to determine how well it's doing. This is pertinent information for potential investors, so they’ll likely want to see your company’s balance sheet before committing any resources to it. And when used in conjunction with the cash flow statement, changes in balance sheet accounts can be used to calculate cash flow.

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Things to keep in mind about the balance sheet

There are a few key points to keep in mind about your balance sheet. Notably among these is that current assets should be greater than current liabilities to cover short-term obligations. Understanding the balance aspect of the balance sheet is important for this reason.

You can assess your company’s health on the balance sheet by comparing debt to equity and debt to total capital. When referencing your P&L statement alongside your balance sheet, you can assess how efficiently your company is using its assets (and so can potential investors).

Finally, you should know that the balance sheet can be used to evaluate how well a company generates returns. Here are some formulas to keep in mind to help you with that endeavor:

• (Current assets - Inventories) / Current liabilities = Quick ratio
• Current assets / Current liabilities = Current ratio
• Long-term debt / Shareholders’ equity = Long-term debt/Equity ratio
• Total liabilities / Shareholders’ equity = Total debt/Equity ratio

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Find your company’s balance

Now that you understand the fundamentals of interpreting the data contained in the balance sheet, you can gain an objective perspective of your company’s health and take action on items that need attention.

The third (and final) installment in our series on financial statements covers the cash flow statement Missed the first article on the P&L statement? Read it here.0