The balance sheet, explained for business owners

The balance sheet is the report many business owners skip. It looks abstract next to the profit and loss, and its numbers do not seem to change much from month to month. Yet it answers questions the profit and loss cannot: can the business pay its bills, how is it funded, what does the owner really have invested, and is the position getting stronger or weaker? Banks, investors and buyers usually look at the balance sheet early. This guide explains how to read it.

What the balance sheet shows

The balance sheet is a snapshot of the business's financial position on a single date. It lists:

• assets, what the business owns or is owed
• liabilities, what the business owes to others
• equity, the owners' stake, which is what would be left if all assets were sold at their recorded values and all liabilities paid

The three are linked by one equation, which always holds:

Assets = Liabilities + Equity

Every transaction keeps the equation in balance. Buying a $20,000 vehicle with a loan adds $20,000 to assets and $20,000 to liabilities. Earning a profit increases equity, matched by more cash or receivables on the asset side.

Assets

Assets are usually split by how quickly they turn into cash.

Current assets

These are expected to be turned into cash, or used up, within twelve months:

• cash in bank accounts
• trade receivables (debtors), money customers owe you
• inventory (stock), goods held for sale or materials for production
• prepayments, such as insurance paid in advance
• work in progress, for businesses that bill on completion

Non-current assets

These are held for longer than a year:

• plant, equipment and vehicles, shown at cost less accumulated depreciation
• property, if the business owns its premises
• intangible assets, such as goodwill paid when buying a business, or software
• long-term investments and loans made to others, including related entities

Liabilities

Liabilities are split the same way.

Current liabilities

Due within twelve months:

• trade payables (creditors), money owed to suppliers
• GST, PAYG withholding and superannuation owing
• income tax payable
• employee leave entitlements expected to be taken within a year
• the current portion of loans and leases
• credit cards and overdrafts
• income received in advance, where customers have paid for work not yet done

Non-current liabilities

Due later than twelve months: the longer-term portion of loans, leases and hire purchase, longer-term employee entitlements such as long service leave, and sometimes loans from owners or related parties.

Equity

Equity shows how much the owners have put in and left in the business. Its make-up depends on the structure:

• Companies show share capital and retained earnings, which are accumulated profits not yet paid out as dividends.
• Sole traders and partnerships show capital contributed, profits added, and drawings taken out.
• Trusts often show settled sums and undistributed income, with amounts owed to beneficiaries sometimes appearing as liabilities instead.

The choice of structure affects how the balance sheet is presented and how profits flow to the owners. Our business structuring service covers these choices in more detail.

A simple example

As an illustration only, imagine a small business with:

• cash of $50,000, receivables of $80,000 and stock of $40,000, giving current assets of $170,000
• equipment and vehicles of $100,000 after depreciation
• payables of $45,000, GST, PAYG and super owing of $25,000 and a credit card of $10,000, giving current liabilities of $80,000
• a long-term equipment loan of $60,000

Total assets are $270,000 and total liabilities $140,000, so equity is $130,000.

The numbers worth watching

Working capital and the current ratio

Working capital is current assets minus current liabilities. In the example it is $90,000. The current ratio is current assets divided by current liabilities, here about 2.1. A ratio comfortably above one suggests the business can meet its short-term obligations from short-term assets. A ratio below one is a warning sign that bills due soon may exceed what can be collected in time.

Remember that not all current assets are equal. Cash is certain; old receivables and slow-moving stock may not be.

Debtor and creditor days

Compare receivables with sales to estimate how long customers take to pay, and payables with purchases to see how long you take. If customers are paying more slowly over time, cash is being tied up even when the business is profitable.

Debt and gearing

Compare total liabilities, or total borrowings, with equity. A business funded mostly by debt carries more risk if trading turns down, because repayments continue regardless.

Tax liabilities

GST, PAYG withholding and super are held on behalf of others. If these balances are growing from quarter to quarter, the business may be using that money to fund operations, which is a serious warning sign.

Warning signs to look for

• Negative equity, where liabilities exceed assets. It does not automatically mean the business is insolvent, but it needs attention.
• Cash falling while profit rises, often because receivables or stock are growing faster than sales.
• Clearing or suspense accounts with large balances, which usually mean the books are not reconciled.
• Large director or shareholder loan balances. Money moving between a company and its owners has tax consequences, including the Division 7A rules where a private company lends to or pays shareholders and their associates. Keep these accounts tidy and discuss them with your accountant every year.
• Overdue tax obligations, which can lead to penalties and, for companies, personal exposure for directors in some circumstances.

Directors of companies also have a duty not to let the company trade while insolvent, that is, when it cannot pay its debts as and when they fall due. The balance sheet and a cash flow forecast together are the first tools for seeing that risk early. If you have concerns, seek advice promptly.

Reading the balance sheet with the profit and loss

The two reports work together. The profit and loss explains how equity changed over the period through trading; the balance sheet shows where the resulting money ended up, whether in cash, stock, receivables, equipment or debt repayments. Reviewing both each month, as part of a regular month-end close, gives a far more complete picture than either alone.

How we can help

If you would like help understanding your balance sheet, tidying up loan and clearing accounts, or reviewing how your business is structured and funded, we are happy to talk. See our accounting services or contact us.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.