A balance sheet is like a road map of your business’s financial state. Learn more about balance sheets and how to better run your finances here.
Balance sheets explained
A balance sheet is a financial document that provides a thorough overview of a company’s financial position. The balance sheet reports the company’s assets, liabilities, and shareholders’ equity to evaluate what the company owns and owes.
Why is the balance sheet important?
Companies in the UK are required to create a balance sheet as part of their annual accounts, so they are first and foremost a statutory requirement. This account sheet is important to financial reporting because it shows what transactions took place in a given period, and how the incoming and outgoing cash is used.
Showing financial health
Having a clear series of balance sheets can help your company secure partnerships and investments, by showing other parties that you have a solid financial background. If you’re looking to raise money through a loan or sale of equity, then your balance sheet is essential. It’s smart to keep your balance sheet updated in case you need to make a short-term request for finance.
In other cases, your balance sheet could alert you to potential gaps in cash flow. For example, if your balance sheet assets show a high number of payments from customers that are being counted as assets but the cash flow doesn’t match, this can suggest it’s time to take a fresh look at your accounts receivable processes and other ways to improve your cash flow.
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Making informed decisions
Keeping a close eye on your balance sheet statement helps you to make informed business decisions. Over time, a company balance sheet can reveal trends around revenue and cash flow that give you the confidence to make investments or an early warning of a need to cut expenses. While it’s important to look at your new balance sheet and latest figures, it’s also important to look at trends over time. Are certain balance sheet items increasing or decreasing, and could that suggest a bigger issue?
What are the main elements of a balance sheet?
A company’s balance sheet is usually divided into three sections: assets, liabilities and equity. Every balance sheet statement will look slightly different depending on the kind of assets and liabilities it has, and how it is owned. For example, a software company won’t list inventory on its balance sheet, since it does not hold physical stock.
Here are what the main parts of a balance sheet refer to:
- Assets – divided into current assets and noncurrent assets. Current assets include valuables such as cash, vehicles, and equipment. Noncurrent assets are valuables that can’t be easily liquidated in less than a year, such as land or buildings, or even patents and copyrights.
- Liabilities – divided into current and long-term liabilities. Current liabilities include accounts payable (expenses you’ll be paying out in less than a year, including salaries, utility bills, and leases). Long-term liabilities are money you owe that won’t need to be repaid within a year, such as debt financing or a government-backed loan.
- Shareholder’s equity – the initial amount of money already invested in the business.
For further details on each of these different elements, a step-by-step guide on how to prepare one, and a balance sheet template, click here.
How to understand a balance sheet
To understand a balance sheet, it’s important to think about the three elements - how do they relate to each other and how have they changed over time?
A company that has many assets with few liabilities could be holding on to cash that it could use in other ways. Meanwhile, if your business has few assets and high liabilities, there could be a risk of running out of cash. If the level of cash is falling over time, that could be a sign to look for ways to increase cash flow, perhaps by improving the efficiency of inventory or looking to cut costs.
Business owners can also use ratios to understand a balance sheet and get an idea of their company’s financial health. These include:
- Working capital ratio - to help give a better understanding of cash flow
- Financial gearing ratios - to understand the business's reliance on debt
How to keep your balance sheet updated
You should amend the balance sheet whenever there is a change in the business’s assets or liabilities. For example, if you sell a piece of key equipment or upgrade it so that it increases or loses value for a reason, you must add that to the balance sheet. If you take out any additional loans, sell property, or change company cars, your balance sheet will need to be updated.
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How your balance sheet relates to cash flow
While your balance sheet does not specifically show your cash flow, it works very closely alongside cash flow forecasts. This is another reason to keep your balance sheet current, as it will help you to understand what is coming into or going out of your business at any time. An accurate cash flow forecast means you can look ahead to ensure you will have enough funds to cover future bills, such as tax, VAT, or pension liabilities for your employees, as well as ensure you won’t end up paying suppliers late.
Having a good handle on your cash flow is essential to running your business effectively. But without a clear and structured balance sheet with all liabilities outlined, your cash flow forecasting cannot be as effective, which puts your company’s financial future at risk.
Keeping your balance sheet in good order is vital for managing your business finances. It can help improve your cash flow, gain financing, and make quick and beneficial decisions at all stages of your business.
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