19. Aug 2019 |

What is a Balance Sheet and Why is it Prepared?

A balance sheet is one of the most fundamental reports in accounting, giving its reader a snapshot of the financial standing of a business at a given point in time. If you’re unfamiliar with making sense of financial reports, a balance sheet is a good report to start taking a look at to familiarize yourself with the type of information they can give you.

Viewing balance sheets on a regular basis, usually once a month, is a good way to check up on the financial health of your business – but a balance sheet isn’t the only representative of the transactions in that month. Unlike an income statement or a cash flow statement which analise the financial results of a specific period, the balance sheet represents the accumulation of the total wealth of a business.

What is a Balance Sheet
The balance sheet is important to show the financial health of your business. (© Unsplash)

What is a Balance Sheet?

As its name suggests, a balance sheet shows you a balanced comparison between assets, liabilities, and equity so that everything a business owns and owes is accounted for. The basic equation of a balance sheet is Assets = Liability + Equity. So the “balancing” the balance sheet is doing is to make sure the two sides of this equation match, meaning that an increase in assets must also mean an increase in either liability or equity and vice versa. To fully understand this equation, it’s important to have a solid idea of what assets, liabilities, and equity are.

Assets

Assets are everything the company owns – from cash and accounts receivable to furniture and property. Assets can also include things like patents and permits. Assets are usually listed first on the balance sheet (or in the left-hand column, depending on the format) and arranged in order of liquidity, or their ability to be quickly turned into cash. Cash itself is listed first, often followed by accounts receivable, inventory, and other things also known as “current assets”. Fixed assets are often listed at the bottom – these are assets that usually have a life of a year or more, such as furniture and vehicles. To the right is an example of asset accounts listed on a balance sheet, totalling £31,000.

Example of Assets

CURRENT ASSETSQ1
Cash

£14,000

Accounts Receivable

£7,500

Inventory

£500

TOTAL CURRENT ASSETS

£22,000

 

FIXED ASSETSQ1
Furniture and Fixtures

£4,000

Equipment

£5,000

TOTAL NET FIXED ASSETS

£9,000

TOTAL ASSETS£31,000

Liability

Liabilities, on the other hand, are money the company owes – so things such as accounts payable, loans, and long-term leases fall under this category. They are usually listed in the same order as assets, with current liabilities such as accounts payable, rent, and other debts due within the year at the top.

Longer-term liabilities such as large debts are listed at the bottom. In this example, the business owner has one long-term debt of £20,000.

Equity

Equity is what is left over when liabilities are subtracted from assets – essentially the net worth of the business. It represents the amount of money the owner could claim if the entire business was liquidated, not available money in the bank. In cases where a company has multiple shareholders, there may be additional accounts for types of stock holdings.

Example of Liabilities and shareholders’ equity

CURRENT LIABILITIESQ1
Accounts Payable£5,000
Interest Payable£1,000
Wages Payable£1,350
TOTAL CURRENT LIABILITIES£7,350

 

LONG-TERM LIABILITIESQ1
Long-Term Debt£20,000
TOTAL LONG-TERM LIABILITIES£20,000

 

SHAREHOLDERS’ EQUITYQ1
Capital Stock£2,000
Retained Earnings£1,650
TOTAL SHAREHOLDERS’ EQUITY£3,650
TOTAL LIABILITIES AND EQUITY£31,000

In this example, the business owner has £31,000 in assets and £27,350 in total liabilities – so their total equity is £3,650. In this way, the balance sheet assets of £31,000 equal the combined liabilities and equity of £31,000.

Balance Sheet Accounts

The accounting general ledger assigns a different account for recording every type of monetary transaction. It is made up of two types of accounts: temporary accounts and permanent accounts. Temporary accounts are accounts which are closed at the end of the year, or their balances are transferred to permanent accounts – so accounts such as expense and revenue accounts are temporary because they are closed at the end of an accounting period. Permanent accounts are accounts whose balances accumulate from year to year, so the balances recorded at the end of one year become the beginning balances for the next year. These are accounts such as cash, accounts payable, accounts receivable, and inventory. The balance sheet is made up of only permanent accounts, because it doesn’t cover financial activity over a particular period.

Balance sheets can be very simple or extremely complicated depending on the size of the business and number of permanent ledger accounts they have. Smaller businesses will often have a simple ledger and smaller balance sheet, whereas larger businesses that have a lot of transaction types will have many more categories of accounts listed on their balance sheet.

Why are Balance Sheets Important?

Balance sheets are important to be able to gauge the overall success of a business venture. At a glance, they enable you to see everything that has gone into a business, and whether it is succeeding or not. A balance sheet doesn’t give you the whole picture – it’s also important to look at cash flow statements, income statements, and other reports to get a better perspective on how to manage your money. But a balance is a good first step towards financial literacy in business and should continue to remain one of the main reports you generate each month to help you stay on top of things.

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