Advantages of a Balance Sheet: 3 Reasons to Use One and How to Get Started

As a small business owner, you know how important it is to make the most of every tool that’s available to run a better business. That’s why every entrepreneur should be taking advantage of the balance sheet. What is a balance sheet and why should you care?

A balance sheet is one of the three financial statements that, taken together, give you a picture of the overall financial health of your business. (The other two financial statements are the cash flow statement and the profit and loss statement, sometimes called the income statement.)

A balance sheet is more than just a spreadsheet to file away with your financial documents. It can help you in many ways. In this post, I'll explain what a balance sheet is, the components of a balance sheet, and how to use a balance sheet.

What are the advantages of a balance sheet?

It may help to think of your business’s balance sheet as a scorecard or report card that shows the status of your business’s finances at a given moment in time. The balance sheet records your business’s assets, its liabilities, and the owners’ equity (also called shareholders’ equity) in the business.

What is a balance sheet's purpose? It can do several valuable things for a small business owner.

• A balance sheet shows you the big picture. When you’re running a business today, it’s easy to get focused on whether cash is coming in or not, whether you can pay your bills, and if you’re making payroll. A balance sheets goes beyond this short-term view to show your business’s progress over time.

• A balance sheet helps you measure the value of your business. You may not be planning to sell your business anytime soon, but having an idea of its value (that is, the owners’ equity) can give you insight into your options for its future.

• A balance sheet can serve as an early warning system. Between the beginning and the end of the year, is your owners’ equity growing or shrinking? A well-run business should produce growing equity. If your business isn’t doing this, looking at the specific assets and liabilities on your balance sheet can help you find out why. For example, if most of your assets are inventory, that’s risky. Inventory that doesn’t sell quickly becomes a liability.

Components of the balance sheet

A balance sheet has three sections: assets (what the business owns), liabilities (what the business owes, both now and in the future), and owners’ equity (assets + liabilities). Let’s take a closer look at each.

1. Assets

Assets include current assets, fixed assets, and other assets. Current assets include:

• Cash
• Accounts Receivable
• Inventory
• Assets that can quickly be converted to cash such as certificates of deposit

Fixed assets are long-term assets that your business will have for more than 12 months. They include:

• Equipment
• Buildings
• Land
• Vehicles

You may also have intangible assets, such as trademarks or patents.

2. Liabilities

Current liabilities are those that need to be paid within the next 12 months, such as:

• Accounts payable
• Taxes
• Payroll
• Debt service
• Credit card payments

Long-term liabilities will not be paid within the next 12 months. These include:

• Outstanding loans (minus the current portion of these debts)
• Mortgages

3. Owners' or shareholders' equity

Add together assets and liabilities to arrive at your owners’ equity or shareholders’ equity. Ideally, this should be a positive figure, but if things aren’t going well, it could be a negative number.

If your owners’ equity remains negative, it will affect not only your profitability, but also your ability to get capital from lenders or investors. Financing sources want to see that a business is doing well enough financially to service its debt or make a profit for investors before they will put any money into your business.

More articles from AllBusiness.com:

• Business Expenses to Re-Evaluate During an Economic Downturn
• How to Avoid Chargebacks and Protect Your Small Business
• Are You Micromanaging Your Company’s Financial Tasks?
• 5 Simple Ways to Improve Your E-Commerce Accounting Practices

What to pay attention to on your balance sheet

Because they look out over a 12-month period, balance sheets are a good way to get a long view of your business’s financial situation. With your balance sheet at hand, you can run some numbers that will give you an indication of your business’s overall financial health:

Current ratio: Divide current assets by current liabilities; this number should be at least 1.0 and ideally closer to 2.0.

Debt-to-equity ratio: Divide total liabilities by owner’s equity; the lower this ratio is, the better.

And here are questions to ask yourself about your balance sheet:

• Is the bulk of your assets inventory? This could be a sign that you are holding too much inventory, which costs money to store and may have to be sold at a loss.
• How much of your assets are cash or current assets? If you don't have access to ready cash, this can cause problems for your business. For one thing, you won't have money to invest in growth or expansion.
• Are you collecting on your accounts receivable in a timely fashion? Assets you don't have in hand can't contribute to your business.

What can you learn from a balance sheet?

A balance sheet gives you a full picture of your business’s finances, one that takes into account all of your assets and all of your liabilities—including those that aren’t part of your cash flow statement. With this birds-eye view of your business, you can make necessary changes, such as:

• Adjusting your purchasing process and inventory management
• Converting more of your assets to current assets
• Improving your collections methods to get paid on time

A balance sheet is also essential if you're trying to get a business loan from a bank or capital from investors. Here are some things potential financing sources will look at on your business statement:

• Are you retaining enough earnings in the business? If you’re distributing all of your profits, bankers and investors will worry that you don't have enough of a "cash cushion" to get you through a downturn.
• Are your financial statements professionally done? While you can create your own balance sheet (and you should definitely know how to read your balance sheet), if you're looking for capital, have an accounting professional prepare this and all of your financial statements. Aside from saving you time, professionally prepared financial statements are considered more reliable than those generated inside a business.
• Do you have skin in the game? A balance sheet may reveal that your business relies too heavily on lenders or investors. If you don't have a reasonable amount of owner’s equity, financing sources may doubt your commitment to the business should things get rough.

What's your business worth?

Ultimately, a balance sheet calculates the value of your business. Even if you aren't planning to sell your business in the near future, think of it as a way to keep score.

You may find out your business is less successful—or more successful—than you thought it was. Most people greatly overestimate the value of their businesses, so getting a reality check can be helpful. By pinpointing shortfalls in your business’s finances, a balance sheet can help you make long-term changes that will improve your company's chance of success.

While it may sound like overkill if you are a one-person company or a very small business, a balance sheet is actually a valuable tool for businesses of all sizes to monitor their progress and see how they’re doing.

RELATED: Looking to the Future: 5 Steps to Better Financial Projections During Covid-19