Why You Can’t Afford To Ignore Understanding Your Balance Sheet
It’s often said that every business owner should have a good understanding of all their financial statements, especially understanding your Balance Sheet…but why? Well, think of it this way. Your balance sheet is like a report card for your business, that shows you how much money you have, how much you owe, and what you own.
So it’s a snapshot of your company’s financial health, that can help you understand your current financial position and ultimately help you make better-informed decisions. By paying close attention to your Balance Sheet:
- You can identify potential issues and make informed decisions
- You can manage your cash flow and liquidity (stay financially stable)
- You can make better-informed investments or borrowing decisions (or give clear information to potential investors and creditors)
- You can identify potential issues with debt and take steps to manage it quickly
- You can plan for the future
But, What Is A Balance Sheet?
Initially, your balance sheet may seem intimidating, but it’s actually quite simple to understand. It consists of two parts:
The top half of a balance sheet shows the company’s assets, which are resources that the company owns and that has value, such as cash, inventory, property, and equipment.
The bottom half of a balance sheet shows the company’s liabilities, which are obligations that the company owes to others, such as loans, accounts payable, and taxes owed. Equity, which represents the residual interest in the assets of the company after deducting liabilities, is typically shown below liabilities.
The top half should always equal the bottom half, hence the name balance sheet!
Fixed Assets And Current Assets
The top half of your balance sheet lists all of your assets, starting with your fixed assets. That’s things like land, buildings, property, motor vehicles, IT equipment, or anything that’s used in the business for a prolonged period of time. Current assets come next and include stock, work in progress, prepayments, other debtors, trade debtors, and bank & cash.
Fixed assets are long-term things that your company owns and uses to run its business, such as property, equipment, and machinery. These assets are not intended to be sold quickly and are expected to last for more than a year. For example, heavy machinery, such as bulldozers, excavators, and cranes, that are used for earthmoving, grading, and lifting operations.
On the other hand, current assets are things that your company owns that can be converted into cash relatively quickly, usually within a year or less. Examples of current assets could be raw materials and supplies, such as lumber, steel, cement, and electrical components, that are used for ongoing projects. These assets are meant to be used or sold quickly to generate cash for the company’s daily operations.
So, fixed assets are long-term resources that a company owns, such as property and equipment, while current assets are things that a company owns that can be converted into cash quickly, such as inventory and accounts receivable.
Liabilities – What You Owe To Others
The liabilities half of the balance sheet shows the debts your company owes to others and are categorised as either long-term or short-term liabilities.
Long-term liabilities are your debts that are expected to be paid back over a period of more than one year. For example, if you took out a loan to purchase equipment, you will have to make regular payments over several years to pay off the loan.
Current liabilities are debts that are expected to be paid back within a year or less. Examples of short-term liabilities might include accounts payable, HMRC Tax or short-term loans.
The Difference Between Current Assets And Current Liabilities
Net current assets are the term for the difference between your current assets and current liabilities. Most businesses aim to have a positive net current assets figure as it shows they can pay their bills as they fall due. If your current liabilities outweigh your current assets, you will likely face liquidity problems.
The ‘Financed By’ Section
The last section of the balance sheet shows how your net assets are funded, which is known as the ‘financed by’ section. It includes your ordinary share capital, share premium, and other reserves. However, the key part of this is retained profit. That’s the profit you’ve generated from the business that you haven’t taken out as a dividend. The sum of all these parts comes to your shareholder funds, which should equal your net assets (total assets less total liabilities).
Treat Your Balance Sheet Like A Tool
Your balance sheet is an important tool in your financial toolbelt that can help you understand how your company is performing.
By understanding it you can identify potential issues that could negatively impact your company’s long-term prospects. For example, if you have high levels of debt, you may have difficulty making payments or securing additional financing. If you’re not generating enough cash flow to pay your bills, you may struggle to grow or take advantage of new opportunities.
There are lots of other issues that can be identified through the balance sheet, for example:
- poor asset quality
- inefficient use of assets
- inventory management problems
- declining profitability
- poor management, and
- regulatory compliance issues
These problems can be problematic for any company because they can negatively impact its financial stability and reputation. Plus they could impact your ability to attract investment or on lending decisions.
The Bottom Line: You’ll Understand Your Business If You Understand Your Balance Sheet
By understanding your balance sheet, you’ll know your numbers and, in turn, know your business. You’ll be able to see where your company stands financially and use this information to make better business decisions.
Want to change your relationship with your company’s financials? Join our next KYN Mastery Group, where we help you take your learning to another level. You’ll learn how to master your finances and take that learning and apply it in your business.
