You have to understand that the importance of recording financial information goes beyond just knowing what you earned or spent on a monthly or yearly basis. It helps you make relevant financial decisions that affect the health of your business. But you can’t do this well enough if you can’t read and interpret financial reports like balance sheet, so what’s stopping you?
As a business owner, you need to be able to read and interpret information, relying on your accountant solely for such interpretation can be a deadly mistake.
What’s a balance sheet? A balance sheet is a financial document that communicates exactly how much a business is worth. It reveals the firm’s assets, liabilities and equity. It is also called the “statement of financial position” which speaks to its relevance in a business.
There are three terms you need to understand to understand how to interpret your balance sheet:
- Assets – An asset is something of value a company owns. It is usually divided into two parts; current and non-current asset depending on how easily they can be converted into cash. An example of a current asset is cash and it’s equivalent while an example of a non-current asset is land and equipment.
- Liabilities – A liability is what a business owes. Unlike assets, it is something of value that is owed to creditors, suppliers etc. They are also divided into short and long-term liabilities depending on when they have to be paid. A good example of short and long term liabilities is rent payment and long term loan respectively.
- Equity – This is the share of the business that belongs to the business owners or shareholders after their liabilities has been taken out. It is the assets of the business minus the liability.
Rules of a balance sheet
- A balance sheet should always balance. That is Assets always = Liabilities + Equity. In other words, the balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders’ equity.
- Assets in a balance sheet are calculated as positives while liabilities are calculated as negatives.
- Equity must always equal assets minus liabilities. Liabilities must always equal assets minus owners’ equity.
Now, with this breakdown, you should have a fair understanding of how to interpret your balance sheet. But you have to practice to get better, so take out your latest balance sheet and try to read it and interpret what it means for your business. If you don’t have one yet feel free to search google for balance sheet examples and read them.