The balance sheet is a crucial financial statement, alongside a profit & loss statement and cash flow statement. Each one answers a different question about your business: P&L shows your profitability; cash flow is how money moves in and out of your business; and the balance sheet gives a snapshot of what you own and owe.
According to the accounting principle, everything on your balance sheet must “balance”: assets equal liabilities plus equity. If the numbers don’t add up, something has gone wrong. But even when a balance sheet perfectly balances, a business can still have weak spots.
Let’s look at how to read a balance sheet, understand the numbers, and catch the warning signs of a fragile business.
The Balance sheet: Assets, liabilities and owners’ equity
Your balance sheet is made up of three components: assets (current and non-current), your liabilities (current and non-current) and owners’ equity.
Assets
On a balance sheet, assets are separated into current and non-current, ranked by their liquidity (how easily an asset converts to cash). Here are some examples:
| Current Assets | Non-current Assets |
|---|---|
| Cash | Coffee machine |
| Inventory | Cafe furniture and fittings |
| Prepaid expenses | |
| Accounts receivable |
Liabilities
Beneath your assets go your liabilities, separated identically into current and non-current obligations. In your balance sheet, liabilities represent the funding source for your assets — the give-and-take part of the accounting equation.
| Current Liabilities | Non-current Liabilities |
|---|---|
| Accounts payable | Long-term debt |
| GST payable | |
| PAYG payable | |
| Superannuation |
Equity
Equity is what remains after assets and liabilities are subtracted: this is what you own in the business. Depending on the structure of a business, some components of equity differ. For sole traders and partnerships, there is a single capital account that is updated with contributions, profits, and drawings.
Interpreting your balance sheet
Interpreting your balance sheet comes down to having accurate information and asking the right questions.
First, ensure your accounting data is accurate. If profit is presented incorrectly in your P&L, it affects owners’ capital and retained earnings, and incorrect inventory figures can have flow-on effects that negatively impact your cash flow.
Secondly, when your balance sheet balances perfectly, ask yourself these vital questions:
- Can you pay what’s due?
- What does your business actually own?
- What’s funding your business?
Going through each section of your balance sheet will answer these questions and tell you whether your business is strong or fragile.
Current assets vs current liabilities: Can you pay what’s due?
It’s vital for a business to service its debts — otherwise, you can’t operate. This is the first question you need to answer from your balance sheet.
The ability to pay your debts is represented in your working capital.
Working capital = current assets – current liabilities
Positive working capital means you can reliably meet your obligations; negative working capital means the opposite, but it can be band-aided by improving supplier terms or refinancing debt.
It can also be presented as the current ratio, calculated by dividing your current assets by your current liabilities. Ratios above 1.0 mean positive working capital; below, mean negative.
Marty's cafe
Current assets
Current liabilities
Working capital
$6,200
Ratio: 2.48 — comfortably above the 1.2–2.0 healthy range
You also need to be aware of what’s called the ATO bundle: GST payable, PAYG withholding, and superannuation contributions. These are obligations in which you hold money collected on someone’s behalf. When you generate your balance sheet each month/quarter, the figures should generally stay the same (depending on hours worked and income generated). If these double suddenly, you may have missed your obligations and spent money intended elsewhere.
Book value vs market value: What do you actually own?
The next question is: what does your business actually own? This helps decipher the value of your business and gives context to your operations. Key to this is understanding the difference between book value and market value. A common misconception is that book value and market value are the same figure. They’re not. Book value is what something is worth according to the business’s own records. Market value is what a buyer would actually pay for it.
Marty's cafe
Understanding book value and market value matters because business owners, investors, and banks all make decisions using the numbers on a balance sheet. Book value and market value answer different questions, and relying on just one can harm a business.
Debt vs retained earnings vs owner capital: What’s funding the business?
Where your business’s funding comes from helps you assess the solvency of your operations. Unlike what you owe, this is a survivability question, represented by the debt-to-equity ratio.
Debt-to-equity = total liabilities/owners’ equity
Calculated on a scale of 1.0, numbers below 1.0 mean a business gets its funding more from ownership, while numbers above 1.0 mean it relies more on debt financing.
Depending on your industry, a higher debt-to-equity ratio may be ideal, whereas overreliance on equity funding could mean you can’t secure business loans or are cannibalising retained earnings. Instead, find the right balance to sustain your business operations.
Marty's cafe
Paid first. If Marty closed the cafe tomorrow, the lender is owed this before anyone else touches what's left.
Paid last, and only what's left. This is not a cash reserve. It grew by $1,120 in profit and shrank by what Marty drew out. It also is not what the cafe would sell for, since a buyer pays for goodwill and customers too, not just the numbers on this page.
Debt-to-equity
0.97
Just under 1.0 — Marty's slightly more owner-funded than debt-funded.
Another key point here is that the capital account reflects the accumulated investment in a business: profit increases it, while drawings (an owner taking money out of a business through cash or inventory) reduce it.
There is an enduring misconception that the capital account (or a company’s retained earnings) is simply a cash reserve ready to be distributed, when in reality it is a mixture of assets. Getting this wrong can make a business look profit-rich but cash poor.
Finally, in the example, if Marty sold his cafe, the owner’s equity wouldn’t reflect the sale price, since it doesn’t account for intangible values such as goodwill, the customer base, or what a buyer would actually pay to run the business.
A strong balance sheet vs. a fragile balance sheet
Now that we know what we are looking for, let’s look at Marty’s balance sheet to find examples of what a strong and fragile balance sheet looks like.
Marty's cafe — balance sheet
Current assets
Non-current assets
Current liabilities
Non-current liabilities
Working capital ratio
2.48
Debt-to-equity
0.97
In the strong balance sheet, Marty has a working capital ratio (current ratio) of 2.48, which means the business can comfortably meet its short-term commitments. Marty can also see the clear value in his assets and what the business owns. Lastly, Marty doesn’t rely heavily on debt financing (as seen in his debt-to-equity ratio of 0.97) to operate his business. All this allows Marty to either redistribute excess cash or secure debt financing to invest in and grow the business.
On the other hand, the fragile balance sheet shows cracks. A working capital ratio close to 1.0 and a debt-to-equity ratio of 3.95 mean that Marty only just meets his short-term commitments and relies heavily on loans to fund his operations.
Mastering your balance sheet
Understanding your balance sheet requires a good sense of your business, with added context from your profit & loss statement and cash flow statement. This is what it means to balance your books. By using accurate information and asking the right questions, you can identify your business’s strengths and tackle issues before they spiral out of control — leaving you with a stronger, more resilient business.
