Understanding your Balance Sheet print Print

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Many business owners find the Balance Sheet the hardest financial document to understand and interpret. This guide offers a simple explanation of the Balance Sheet, relates it to the Profit and Loss statement, and explains how you can use it to better manage your business.

Tips on monitoring your business' performance


Your Balance Sheet

The two major financial statements produced at least yearly by most businesses are the Profit and Loss statement and the Balance Sheet. This guide should therefore be read in conjunction with the Solution Guide, 'Understanding your Profit and Loss statement' as the two documents work together.

Structure of the Balance Sheet

In simplest terms, the Balance Sheet is made up of three components: Assets, Liabilities and Owner's Equity. The purpose of the Balance Sheet, as its name suggests, is to balance these. For this reason the bottom line figures on a Balance Sheet are always in balance: they match each other. The relationship between the three balance sheet components is best illustrated by the following equation - often called the accounting equation:

Assets = Liabilities + Owner's Equity

Here's a simple example of a Balance Sheet:

Balance Sheet for 2011 Tax Year
Current Assets Current Liabilities
Cash $15,000 Accounts payable $9,000
Account receivable $20,000 Bank overdraft $11,000
Inventory $30,000 Total Current Liabilities $20,000
Total Current Assets $65,000 Long term liabilities -
Fixed Assets - Loan payable $25,000
Equipment $100,000 Total Long term liabilities $25,000

You may well be asking yourself why it's worthwhile making the effort to understand a Balance Sheet. The answer is the same for all financial documents: the ability to interpret a Balance Sheet will help you to manage your business more effectively.


Some definitions

These definitions help to clarify the meaning of the Balance Sheet


Assets are what a business owns. These in turn are divided into fixed assets and current assets.

Fixed assets are assets that will last longer than 12 months, such as buildings, machinery, vehicles and office equipment. These assets will usually be listed on a separate Fixed Asset Schedule which your accountant will keep for claiming depreciation.

Current assets are assets that last less than 12 months and that can be converted into cash either immediately or fairly quickly. For example, the cash in your till, your stock, the savings in your bank account and the money owed to you by customers (debtors).

There's another category of assets: Intangible assets. These include brands, trademarks and goodwill. These are sometimes included on Balance Sheets, but their market value is always debatable.


Liabilities are what the business owes to others. They are usually divided as follows:

Current liabilities are the amounts you owe and will have to repay within a year. For example, outstanding suppliers' invoices (creditors), your overdraft, and taxes due, such as GST, provisional or terminal tax.

Long-term liabilities include lease payments on vehicles or equipment and mortgage repayment on your business premises (if you own the premises).


Owner's equity, also called capital, is the value of a business to its owner after all of its obligations have been met. Owner's equity also represents the owner's investment in an organisation or funds used to set up the business initially.


How does the Balance Sheet relate to the Profit and Loss statement?

The purpose of the Profit and Loss statement is to measure your profitability. For example, the two key figures on the Profit and Loss statement, the Gross Profit and the Net Profit enable you to monitor how efficiently your business is performing, and give you an opportunity to remedy any adverse trends (such as a declining Gross Profit ratio) before they impact too seriously on your profitability.

The purpose of the Balance Sheet is to reflect the strength or weakness of your business at a certain point in time. It is like a quick snapshot on a certain day of your business that measures its financial health. Note that the Balance Sheet could change the very next day. For example, you could sell some stock or assets during the day to meet liabilities. The following day's Balance Sheet would therefore look different.

Unlike the Profit and Loss statement, however, the Balance Sheet reflects the history of your business as well. For example, if you injected $25,000 capital into your business two years ago, this (or its subsequent changes) will be shown in your Balance Sheet. By contrast, the Profit and Loss statement reflects only the income and expenditure for the period it covers (for example, a month or a year).

How often do you need a Balance Sheet?

In the days of manual accounting most small businesses only received a Balance Sheet from their accountant once a year. However, with computerised accounting, and provided your entries are kept up to date, you can produce a Balance Sheet monthly, weekly or daily if necessary. To help you monitor the progress of your business and correct any adverse trends there are obvious advantages in producing a Balance Sheet at more frequent intervals.


Are you solvent?

One of the main purposes of the Balance Sheet is that it allows you to measure your solvency. You need to ensure that at all times your business can meet the solvency test. The solvency test has two parts to it; at all times both of these requirements must be satisfied:

  • The business must be able to pay its debts as they become due in the normal course of business.
  • The value of the businesses assets must be greater than the value of its liabilities, including contingent liabilities.

If your business structure is a company, then you have a special responsibility in terms of the Companies Act 1993 to ensure that at all times your business can pass the solvency test.


How do you measure solvency?

Here are some ratios that will help you determine how solvent your business is:

Current ratio

This tells you if you can pay your bills as they fall due. Check your current ratio by dividing Current Assets by Current Liabilities. For example:

Current Assets:


Current Liabilities:


Ratio: $300,000 divided by $100,000 = 3 (or 300%).

Aim for a ratio of at least 2 to 1 (or 200%), in other words, $2 in assets for every $1 of liabilities, to ensure you're holding adequate funds to meet your short-term commitments. You need greater assets than liabilities at all times. Note: this ratio will depend on the cash cycle of the business, that is, on such factors as stock turn and debtor collection times. Improve these figures and you're likely to improve your current ratio (sometimes called a working capital ratio) as well.

Quick ratio

The quick (liquidity) ratio is an even tougher test than your Current ratio because it leaves out Stock. This is because it's very hard to convert stock quickly into cash to pay bills. So the quick ratio instead measures how much ready money (quick money or liquid assets) you have on hand to pay bills. It's therefore an important ratio for businesses with a lot of money tied up in stock.

Work it out by subtracting the Stock figure from your Current Assets (Cash plus Debtors). Then divide this by Current Liabilities and multiplying by 100 for a percentage. For example:

Current Assets:


(Less Stock of $40,000)


Current Liabilities


Ratio: $50,000 less $40,000 = $10,000 divided by $12,000 =0.83 x 100 = 83%.

In other words, you only have 83% of the ready money you need to pay debts, or 83 cents for each dollar of debt. This ratio signals payment difficulties that could lead to other problems. Aim to have at least 100% or a ratio of 1:1.


Is your Balance Sheet strengthening or weakening?

Comparing a current Balance Sheet with previous ones will show you if your business is strengthening or weakening. Here's one quick test:

Equity to assets (Ownership ratio)

How much of the business do you actually own? Discover this by dividing Owner's Equity by Total Assets (ignore intangibles such as goodwill). For example:

Owner's Equity:


Total Assets (no goodwill):


Ratio: $100,000 divided by $200,000 = 0.5 or 50%.

A low ownership ratio means your business may be undercapitalised, which can lead to unacceptable levels of risk, particularly if trading levels decrease. This is because you have significant levels of debt and borrowings to repay. Your aim should be to ensure that the owner(s) have a satisfactory stake in the business in relation to creditors. Aim for a minimum ownership ratio of 40%.


Notes on the Balance Sheet

Provision for debts

The current assets figure includes all your debtors. But will they all pay? If you don't think this is likely, you'll need to make some provision for bad debts in your Balance Sheet. The longer you're in business, the more accurate your predictions of bad debts are likely to be.

Ask your accountant for advice in this regard, but also remember to set targets for cutting down the bad debt provision as much as possible year by year.


Further information:

To talk to an ANZ Business Specialist:
Call 0800 269 249
Visit anz.co.nz/business
Visit your nearest ANZ branch


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