A snapshot, not a story
A balance sheet shows a business’s financial position on a single date: what it owns, what it owes and what remains for the owner. Where a profit and loss statement describes activity over a period, the balance sheet is more like a photograph taken at the end of the period.
This article is general information. How formal statements must be prepared varies by place, and a qualified accountant can advise on your specific situation.
The core equation
Every balance sheet rests on one relationship:
Assets = Liabilities + Equity
- Assets are things the business owns or is owed that have value.
- Liabilities are amounts the business owes to others.
- Equity is what is left for the owners after liabilities are subtracted from assets. It is also called owner’s equity or net worth.
The two sides always match, because equity is defined as the difference. If you own $14,000 of assets and owe $7,000, equity is $7,000.
Assets
Assets are usually listed with the most liquid items, those closest to cash, first.
Current assets are expected to turn into cash within about a year:
- Cash in the bank and on hand
- Accounts receivable, meaning money customers owe you for invoices already issued
- Inventory, which is stock held for sale
- Prepaid expenses, such as insurance paid in advance
Long-term (fixed) assets are used over many years:
- Equipment, vehicles and furniture
- Buildings or land, if owned
- Other long-lasting items
Fixed assets are typically recorded at cost and reduced gradually over time through depreciation, a method for spreading the cost across the years of use. Depreciation rules, especially for tax, differ by location, so ask a professional.
Liabilities
Current liabilities are due within about a year:
- Accounts payable, which are bills from suppliers not yet paid
- Credit card balances
- Taxes owed, such as collected sales tax not yet remitted
- Wages and payroll amounts owed
- The portion of loans due in the next year
Long-term liabilities are due later, such as the remaining part of a multi-year loan. Understanding the terms attached to any borrowing is part of knowing the real cost, as the discussion of business loans explains.
Equity
Equity typically includes:
- Owner’s contributions: money the owner has put into the business.
- Retained earnings: profits kept in the business over time rather than paid out.
- Owner’s draws or distributions: money taken out, which reduce equity.
How equity is labeled depends on the business structure. A sole proprietorship often shows a single owner’s equity figure, while a corporation shows share capital and retained earnings.
A hypothetical example
The following numbers are invented for illustration only:
Assets
- Cash: $4,000
- Accounts receivable: $1,500
- Inventory: $2,500
- Equipment: $6,000
- Total assets: $14,000
Liabilities
- Accounts payable (suppliers): $1,200
- Credit card: $800
- Bank loan: $5,000
- Total liabilities: $7,000
Equity
- Owner’s contributions: $5,000
- Retained earnings: $2,000
- Total equity: $7,000
Check: $4,000 + $1,500 + $2,500 + $6,000 = $14,000. Liabilities: $1,200 + $800 + $5,000 = $7,000. Equity: $5,000 + $2,000 = $7,000. Liabilities plus equity: $7,000 + $7,000 = $14,000, matching total assets.
How to read it
Look at liquidity. Compare current assets with current liabilities. In the example, current assets (cash, receivables, inventory) are $8,000. Current liabilities, if we treat the supplier bills and card balance as due soon and ignore the loan’s current portion, are $2,000. A comfortable gap suggests the business can cover near-term bills, though the quality of those assets matters: receivables may be paid late, and inventory may not sell quickly.
Look at debt. Total liabilities of $7,000 against equity of $7,000 means the business is funded about half by borrowing and half by the owner’s stake. A heavily borrowed business has less room for error. How much debt is appropriate depends on the business and its ability to repay, and no one should borrow more than they can comfortably repay.
Look at trends. Is equity rising from period to period? Are receivables growing faster than sales, which could signal slow-paying customers? Is inventory piling up?
Balance sheet versus profit and loss
The two statements are linked. Net profit from the profit and loss statement flows into retained earnings on the balance sheet. A business can show a profit and still hold little cash if the money is tied up in receivables or inventory, which is why cash flow deserves separate attention. The balance sheet also tends to look different under the cash and accrual methods, since receivables and payables appear mainly under accrual.
Common mistakes
- Mixing personal and business items, which muddies both assets and equity.
- Forgetting liabilities such as unpaid bills or tax owed.
- Leaving old, uncollectable receivables or obsolete stock at full value.
- Treating loan repayments as expenses instead of reducing the liability.
When it is used
Banks and other lenders often ask for a balance sheet when considering a loan application, since it shows what the business owns and owes. Owners use it internally to monitor financial health, and it supports decisions about borrowing, investing in equipment or paying down debt. If you need a formal version for lenders, tax or a sale of the business, ask a qualified accountant to prepare or review it.