Balance Sheet

A balance sheet is the financial statement that reports a business's assets, liabilities and owners' equity as of a single date, usually the last day of a month, quarter or year. The SEC's plain-language guide puts the logic in one line, "ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY", and describes the statement as "a snapshot" that "does not show the flows into and out of the accounts during the period." Nonprofits call the same statement a statement of financial position; federal student-aid rules, for instance, ask a for-profit school for a balance sheet and a nonprofit one for a statement of financial position.

It is one of three statements a business owner, lender or buyer reads together. The profit and loss statement reports revenue and expenses over a period, the cash flow statement reports cash moving in and out over the same period, and the balance sheet reports where things stand at the end of it. A household's equivalent, everything a family owns and owes, is a personal balance sheet; it follows the same arithmetic but answers a different question.

Why the two sides always match. Equity is defined as what is left after liabilities are subtracted from assets, so the equation holds by construction. Every transaction is recorded in at least two places. Borrowing $10,000 raises cash and a loan payable by the same amount. Paying a supplier lowers cash and accounts payable together. Earning a profit raises assets, or lowers liabilities, and raises equity by the same amount. A balance sheet that does not balance signals a bookkeeping error, not a business result.

Current and long-term. Assets are listed roughly in order of how quickly they become cash. In the SEC guide's terms, current assets are those a company "expects to convert to cash within one year", such as cash, receivables and inventory, and noncurrent assets include fixed assets like vehicles, equipment and buildings. Liabilities divide the same way: current liabilities are due within the year, such as payables, credit card balances, the current portion of a term loan and taxes owed, and long-term liabilities are due later. The difference between current assets and current liabilities is working capital, the first thing a lender checks.

The equity section depends on the entity. A corporation reports shareholders' equity, which the SEC guide describes as "the amount owners invested in the company's stock plus or minus the company's earnings or losses since inception"; earnings paid out as dividends leave it. A sole proprietorship or single-member LLC usually shows an owner's capital account, increased by money the owner puts in and by profit, and reduced by losses and by owner's draws. A partnership keeps a capital account for each partner. In every case equity is a residual: it is what the books say the owners would have left if every asset were realized at its recorded amount and every debt paid.

Book value is not market value. Equipment and buildings are carried at what they cost, less accumulated depreciation, so a building bought twenty years ago can sit on the books far below what it would sell for, and a fully depreciated machine can still be valuable. Assets a business built itself, such as its reputation or customer relationships, generally do not appear at all. That is why a valuation built on earnings, such as a multiple of seller's discretionary earnings, can land far from book equity, and why equity on the balance sheet is not the price of the business.

Where the IRS sees one. A partnership return includes a balance sheet, Schedule L of Form 1065, which a small partnership meeting the return's own size tests can skip. Public companies file balance sheets in the format SEC Regulation S-X prescribes, which is why their statements are the easiest to compare.

Take an example of a small business's balance sheet on December 31.

Assets. Cash $18,000, accounts receivable $12,000 and inventory $20,000 make current assets of $50,000. Equipment with a cost of $65,000 and accumulated depreciation of $25,000 adds $40,000. Total assets are $90,000.

Liabilities. Accounts payable $15,000, a line of credit balance of $10,000 and the $5,000 of a term loan due within the year make current liabilities of $30,000. The rest of the term loan, $25,000, is long-term. Total liabilities are $55,000.

Equity. $90,000 − $55,000 = $35,000, the owner's equity.

Three readings follow directly. Working capital is $50,000 − $30,000 = $20,000, and current assets cover current liabilities $50,000 ÷ $30,000, or about 1.67 times. Debt to equity is $55,000 ÷ $35,000, about 1.57, meaning creditors have more invested in the business than the owner does.

Now suppose the owner borrows another $10,000 on the line of credit in January and leaves it in the bank. Cash rises to $28,000, so total assets are $100,000; the line of credit rises to $20,000, so total liabilities are $65,000; and equity is still $100,000 − $65,000 = $35,000. The business is no richer for borrowing, and the balance sheet shows that while working capital is unchanged, its debt to equity has risen to about 1.86.

Pros

• Shows in one page whether a business can meet its near-term obligations and how much of it is financed by debt rather than by its owners.
• Ties the other statements together: the year's profit flows into equity, and the cash flow statement explains the change in cash between two balance sheets.
• It is what lenders, buyers and partners ask for, so keeping one current makes financing and sale conversations faster.

Cons

• It describes one day. A business can look strong on December 31 and be short of cash in March.
• Book values can be far from market values, in either direction, and internally built goodwill is usually invisible.
• For a small business on the cash method, receivables and payables may not be recorded, so the statement can understate both sides.
• Its accuracy depends entirely on the bookkeeping; mixed personal and business accounts make it unreliable.