Are you reading your balance sheet every month? Some of my clients admit that it is a little bit intimidating to them. It just wasn’t something they were taught to do. By going over a sample balance sheet with them, I bring it much closer to them, in the hope that if they become familiar with it, they will make better business decisions because they will have one more tool.

You can use a balance sheet template to play with the numbers and practice your skill.

Preparing Accurate Financial Statements

To begin, we need accurate financial statements. It’s not always as simple or as obvious as it may sound. Many small business owners, when they first come to me, complain about never having had a correct balance sheet.

They had a family member do their books and that person had just the basic knowledge of QuickBooks and knew the AR and AP functions.

In order to prepare accurate financial statements for a business, a bit more specialized accounting knowledge is needed. So, let’s get the financials first.

Reading a Balance Sheet

Now we can start reading our balance sheet by understanding its main categories – assets, liabilities and equity. These three components are quite self-explanatory, really. Assets are simply things your business owns, liabilities are the company’s debts and obligations and the equity is the residual value. Your balance sheet needs to always balance and the equation is: Equity = Assets minus Liabilities. Assets and Liabilities are further divided into short-term and long-term.

Everything due within 12 months is considered short-term. Examples of current (short-term) assets are: cash, marketable securities, accounts receivable and inventory. Long-term assets can be items such as: property, plant & equipment (land, buildings, equipment and vehicles) and intangible assets (ex. goodwill, patents and trade names).

The current liabilities typically consist of: accounts payable, current portion of long-term debt, unearned revenues, taxes payable and accrued wages. Common examples of long-term liabilities are: long-term notes payable and bonds payable.

The equity section is usually composed of the following: common stock, retained earnings and net income. The lines of the equity section will be different for different legal entities.

Balance Sheet Analysis

The best way to read and analyze a balance sheet is using ratios, because absolute numbers don’t tell the whole story and do not capture the important relationships between the many components of the balance sheet. Ratios help you stay on track and warn you when you start veering off course.

Balance Sheet Ratios

The most common balance sheet ratios are:

Current ratio = Current Assets / Current Liabilities

Quick Ratio = Current Assets less Inventory / Current Liabilities

Net Working Capital = Current Assets less Current Liabilities

Debt to Asset Ratio = Total liabilities / Total Assets

Debt to Equity Ratio = Total liabilities / Shareholders Equity

A detailed explanation of each one of these ratios is beyond the scope of this article, but I invite you to visit my site for a discussion of balance sheet analysis.