Understanding your balance sheet
Not sure how to interpret your balance sheet? You may be missing out on valuable information about your business performance. I’ll take you through the basics.
What’s a balance sheet?
Your balance sheet is a statement of the financial position of your business, listing all the things the business owns (assets) and all the things it owes (liabilities and equity).
Assets and liabilities
Think of this in terms of your personal balance sheet. For example, you may have assets (things you own) such as a house, a car and funds in a bank account; and liabilities (things you owe) such as a mortgage, credit card debts and a car loan.
As a person, the difference between your total assets and total liabilities is referred to as your net worth. When talking about a business, the term equity refers to the same thing.
Looking at the list of assets and liabilities above, notice that your bank or credit card account will often change daily, whereas the value of your house and mortgage change more slowly. Assets and liabilities in a business are similarly split into current (short lived) and non-current or fixed (longer term).
"If your balance sheet reveals that your liabilities are getting to be greater than your assets, your business may be heading towards insolvency. "
A balance sheet normally lists your assets first, starting with current assets such as the amount of money you have in the bank owed to you by debtors and held as inventory, and followed by your non-current or fixed assets, such as equipment or buildings.
Incidentally, fixed assets are the types of items that tend to be depreciated, meaning that the tax deduction for the expense must be spread across multiple years rather than claimed in a single year.
The next section of your balance sheet relates to your liabilities, again split into current and non-current. Typically, the liabilities of smaller businesses are predominantly current, unless you have some loans or other liabilities that aren’t repayable for more than 12 months.
Current liabilities generally include items such as credit card balances, amounts owed to suppliers or to the ATO (GST and PAYG), and superannuation liability.
One thing to watch for in your balance sheet is a balance showing as a negative number. For example, if any current liability is showing up as a negative number it means it’s an asset, and that someone (such as the ATO) owes you money. If you know that’s not the case it means there’s an error in your accounts.
Net assets and equity
The difference between all your assets and all your liabilities is your net assets, a term that refers to the net value of the things you own in the business. This is different to the net value of the business itself, which is a whole separate topic.
By the magic of double-entry bookkeeping, the value of your net assets will match the value of your equity (the amount that the business “owes” to you as its owner).
Putting your balance sheet to work
Your profit and loss statement (P&L) is the principal document your accountant uses to prepare your tax return, but your balance sheet provides an even more important snapshot of the health of your business. It’s important to keep an eye on yours and use it to correct any concerning issues as a matter of urgency.
If you spot an error in your balance sheet, it’s highly likely that there’s also an error in your P&L, which may in turn lead you to incorrectly report your income to the ATO, leading to bigger issues.
More importantly, if your balance sheet reveals that your liabilities are getting to be greater than your assets, your business may be heading towards insolvency. Note that even if your total assets outnumber your total liabilities, having current liabilities greater than your current assets can create solvency issues – you may not be able to pay your debts when they fall due.
If your balance sheet is looking sickly, don’t wait to act, where necessary, talk to your accountant.
Do you have any questions or comments about balance sheets?