When someone starts a business or company that earns them a penny, the most important thing there is “recording of the incomings, outgoings, and savings.” It will give you a periodic update of where you spent, how much, and when. Considering this need, monk Luca Pacioli introduced a proper method of recording the incomes, expenses, assets, liabilities, and equities of an organization or business. These formats are named as financial statements of the body.
What is a Balance Sheet?
There are generally five financial statements. One of them is the balance sheet which is related to the assets, equity, and liabilities. A business is not just about how much is the profit earned. It is also about how much support a company has to pay off its loans and other liabilities because giving and taking credit makes a business thrive in the long run.
What is a Balance Sheet Made of?
The balance sheet has three general headings, and it is made according to the following formula:
Assets = Liabilities + Equity
Let’s get into this above-stated formula.
Assets are generally considered as something that a company owns in terms of material things of some value. Assets are divided into two different parts. They are current assets and non-current assets.
Current assets are those assets that will benefit you or be turned into cash within twelve months of a year. However, non-current assets are those assets that can be converted into money after twelve months at any time.
Where the assets are related to the company, equity is related to the stakeholders of the company. Once all the assets are used to pay back the liabilities, the remaining assets become the company’s equity. Equity has to be distributed among the partners of the business in the form of dividends, as salaries are given to the employees.
Liabilities are obligations in the name of the company that the company has to pay back. Like assets, liabilities are also divided into two categories: one is current liabilities, and the other is non-current liabilities.
Current liabilities are those that have a maturity date of fewer than twelve months. It means they are to be paid back within the tenure of fewer than twelve months.
However, the non-current liabilities have a maturity date of more than twelve months, i.e., they are supposed to be paid back after twelve months. They are also called long-term liabilities.
Explain the Importance of Balance Sheet
- The balance sheet has another official name called “statement of financial position,” which clearly indicates the purpose of the balance sheet. Any keen person would like to stay updated about the status and position of the company’s finances. Assets are supposed to be more than both liabilities and equities together because this is how you will know that your business is running as a going concern.
- Generally, if the amount of assets falls below the number of liabilities, it signals that your company is going toward bankruptcy. Most businessmen don’t even consider checking the balance sheets until it is too late to do so. In the end, they have to show the bank statements declaring themselves someone who is unable to pay back the liabilities.
- You will get a deeper view of the relationships with your clients and your creditors through the balance sheet. It will show which debtor to write off and which creditor should be paid back first.
- You will know about the declining capacity of your property, plant, and equipment. The assets are written after the accumulated depreciation amount is deducted from them. The net amount shows how much life your asset is left with.
- You will have a better insight of the worth of your business. It will give you an idea of when to invest more and when to not.
- The inventory of your business is shown in the balance sheet. The balance sheet will help you keep updated, so you are never under-stocked or over-stocked.
- Whenever you take a loan of heavier amounts, the financial institutions ask for any document that shows your finances’ health. In the case of a company, that document is the balance sheet. You need to show your balance sheet to ask for a loan. They review it to see your ability to pay back the loan amount within the decided period.
- You will get a better understanding of how your business is running. Some businesses are more equity funded; Equity funding means most investments are made than loans taken by the company to thrive. Other companies are debt-funded, which means loans taken are more than the investments made.
- A balance sheet is compared with previous years to measure the growth in the business. It is also compared with the balance sheets of other companies in the same industry.
- Different investors prefer to see the balance sheet before investing, so it is obligatory to prepare them in the case of public companies.
- A balance sheet can help you identify a lot of problems and solve them. It can help you see the hidden finances which are not letting the company make profits.
- It is easier for a tax officer to file a return when a proper balance sheet is maintained. You will be able to pay the correct amount of tax for your company.
- Internal management prepares all the financial statements of the company. They will be able to identify the lacking areas themselves to promote the growth of the company. Hence, the effectiveness and the efficiency of the staff will be increased with this guide.
- Different financial ratios are calculated based on the amounts written on the balance sheet. These financial ratios provide you deep insights into each area of the business and the comparison with the averages of the industry.
If you want to keep your business in a healthy state of profit, you need to keep yourself updated. You can only make yourself updated if a proper balance sheet is maintained. It is essential for any entity to understand the ongoings of the business, whether it is a small company. For all of this, the balance sheet plays a considerable role.
Matthew is a Co-Founder at BusinessFinanceArticles.org. Matthew was a floor manager at a local restaurant in Wales. He lost his job after the pandemic and took initiative to make a team and start the project.