Your small business may be bringing in revenue. Perhaps sales and assets numbers are favorable. But have you reviewed them against your company’s liabilities? That is what your balance sheet is for.
Like the profit and loss statement, the balance sheet is another crucial report that provides insight into your business’s genuine financial health. It is a simple statement with three categories: assets, liabilities, and equity.
So, why is a balance sheet so important for small businesses? It will guide you and your team and provide prospective lenders and possibly the IRS with essential financial information about your company. Read on to learn exactly what a balance sheet is and why yours should always be updated and accurate.
What is a Balance Sheet?
Your balance sheet shows your company’s assets, liabilities, and equity at the end of an accounting cycle (e.g., quarterly or annually). It provides crucial insights into your business’s performance and helps you make informed decisions. Lenders will also review your balance sheet to verify your company’s financial health.
Let’s quickly define those three categories:
Assets: Resources that your business owns or controls that increase your company's value by generating revenue and profits. Examples include company equipment (i.e., fixed assets), a patent (i.e., intangible assets), or accounts receivable (i.e., current assets).
Liabilities: Money you owe to others, including loans, accounts payable, mortgages, deferred revenues, accrued expenses, bonds, and warranties.
Equity: Also known as shareholder equity, owner’s equity, or net worth, equity reflects the actual value of your business. Your balance sheet calculates this using the simple formula: Total Assets - Total Liabilities = Equity.
Why Your Balance Sheet is Important
Assess Profitability & Debt Ratio
The balance sheet provides a view of current and long-term assets and liabilities in one report, which shows two critical pieces of your financial health:
Your business’s ability to generate cash and profits, and
How to prioritize your financial obligations.
The goal is to have more assets than liabilities. Your balance sheet will indicate if your debt ratio is unsustainable. For example, if your assets total $200,000 and you have $75,000 in debt, your debt ratio is 37.5% ($75,000 / $200,000).
1. Secure Funding
Most potential lenders and investors will look closely at your financials, including your balance sheet, to evaluate your company’s financial position. They want to:
Ensure you will repay your debts on time
Understand what you’ll use their funding for
Have an idea of when they will see a return on their investment
If you plan to sell your company in the future, buyers will also review your balance sheet to be confident they are making a profitable investment.
2. Make Smarter Business Decisions & Avoid Issues
An accurate balance sheet allows you to catch potential cash flow problems early enough to make adjustments and avoid major issues that could be the downfall of your business. Five financial mistakes small business owners make are:
Failing to budget
Spending too much money upfront
Waiting too long to obtain funding
Not staying current with receivables and payables (i.e., what you owe or what clients owe you)
Lacking an understanding of their cash flow
A solid business plan and updated, accurate financials will give you the insight to make wise business decisions. Your balance sheet also tells you whether your business is making a profit. If your equity is not growing, you (or your accountant) will need to look at specific assets and liabilities to determine the hang-up.
It will also give you a proper understanding of your cash balances and current and long-term liabilities, ensuring you always have enough cash to pay your bills on time.
3. Be Ready for Tax Season
Of course, accurate financial records are also vital when preparing your tax returns. When financial statements like your balance sheet are organized and up to date, your CPA will ensure that you don’t pay too much or too little for your business taxes. No one wants to be hit with unpleasant tax penalties at the end of the year.
Not to mention, C corporations must file a balance sheet with their annual return because the IRS wants to confirm that it matches the corporation’s books and records. A balance sheet is not a tax return requirement for small businesses with total receipts and assets less than $250,000 at the end of the year.
Additionally, if you are ever subjected to an IRS audit, they will inspect a complete set of financial statements and receipts. Having an accurate balance sheet is an important piece of this process.
The balance sheet is one of the simplest yet most important financial statements. When done correctly, it will equip you to make more profitable decisions, grow your business, and avoid costly mistakes.
Are your balance sheets updated, or do you need help cleaning up your financial statements? Learn how we can help by scheduling a free consultation or call us at 603-541-7485 today!