What is the balance sheet?

A lot of people tend to overlook the balance sheet but, in our opinion, the balance sheet is quite possibly the most important metric for the financial statement because it can show a lot about how a business is operating. In the case of investors, when they look at a business or real estate portfolio, the balance sheet is what they want to see. The balance sheet tells a story over time and is the source of truth about what's going on with the business. 

Reports as of a Specific Period in Time

A balance sheet reports a snapshot of a certain point in time. It can be used to glean information an investor or lender needs know, such as:

• Can the business afford to pay its bills? 
• What is the book value of the business? 
• Shows the debt to equity mix, or "capital stack", of the business.
• Will show financial historical trends, good and bad. 

Balance Sheet Equation

What is the balance sheet equation? 

Assets = Liabilities + Equity

Often, a company does not own its assets outright. A business has to pay for what it owns (Assets) by either borrowing money (Liability) or through capital inputs (Equity) such as external capital equity. It probably has a loan on the company car, a mortgage on the building, or even owe money to its shareholders. When borrowing money, a business is taking on a liability to pay for those assets. If a business uses external capital to pay for assets, they are using equity to pay for the assets. The amount of the assets will equal the loan amount and equity used to purchase the assets.

Example: If a company takes out a five-year, $4,000 loan from a bank, its assets, or cash, will increase by $4,000. The company's liabilities, or long-term debt, will also increase by $4,000, balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholder equity, again balancing both sides of the equation.

Assets

On the Balance Sheet, assets represent what is owned by the business. Assets are listed in order of liquidity, or how quickly those assets could be converted into cash. In order of liquidity, cash is the most liquid. Accounts receivable can be converted quickly to cash by receiving payments from customers. Inventory can also be converted quickly via sales. Fixed assets and buildings, on the other hand, would take a longer time to convert to cash. Common asset categories in order of liquidity and how they would show up on a balance sheet include:

• Cash
• Accounts Receivable
• Inventory
• Fixed Assets
• Buildings 
• Land 
• Property, Plant & Equipment (PP&E)

Liabilities

Liabilities are what a business owes whether to other people, other businesses, or vendors. Liabilities will be listed in the order in which they will be paid off, with those that can be paid off soonest listed first. 

• Short Term Liabilities
  • Accounts Payable
  • Credit card debt
  • Current portion of long term debt to be paid in one year 
• Long Term Liabilities
  • Notes
  • Mortgages
  • Payables with due date greater than one year

Equity

Equity is what a business is worth and is an important part of the balance sheet to understand, especially as owners get into more of the money raising part of the business cycle. 

• Cash contributed into the business by the owner
• Distribution of profits
• Profits you've retained in the business over time. 

As a business owner, it is important to have an understanding of the various balance sheet metrics. 

Liquidity (Cash) Ratio

The liquidity ratio is a key liquidity measure considered when others are looking at a business, such as investors or banks. 

• Cash ratio for your liquidities shows the value of your business.

• A larger ratio is best so cash and cash equivalence outweigh your current liabilities in the event the business shuts down
• A larger ratio will ensure that liabilities can be paid off. 

Solvency (Current) Ratio

This ratio measures your ability to pay short term debt and higher ratio is better for a business when in a solvency situation.  

Profitability Ratio

The profitability ratio looks at a business's return on assets, or ROA. This will take the net income and divide it by the average total assets over a period of time. It can show how efficiently the business is turning assets into profits. A higher return on assets is going to be a key ratio that someone will look at if they are interested in acquiring a business. 

• A high ROA is good and means that fewer assets are required to make a profit
• An outside investor or outside buyer will look for a high return on assets because that means that the business needs fewer assets to generate a profit.