How to Understand the Balance Sheet of the Business

It is vital to understand the balance sheet and its terms for people who run or invest in a business. In my professional life, I found many small scale business owners are still not able to grasp the language of the balance sheet.

In this article, we explain what the balance sheet is and how to understand the terms used in the balance sheet.

So let us discuss this topic in a non-technical way !!!

What is a Balance sheet

When we try to understand a business organization, we can observe that it owns some resources. These resources may include building, land, machinery, stock, cash etc. We know the business purchased these resources for its use in the business operation to earn a profit. 

How they purchased these resources or what is the source of fund used to purchase these resources. Usually, the capital of the business introduced by the owners is using for the purchase of these resources. There will be other sources of finance also to purchase these assets like Bank Loan, Credit from Suppliers etc.  

The balance sheet is a statement of its funds and how the funds distributed among resources. The resources also called Assets and the fund called Liabilities.  

The balance sheet is the statement of assets and liabilities of the business. It shows the financial position on a particular date.  This position will change when each transaction hit the accounts.

The balance sheet is the statement of assets and liabilities of the business. It shows the financial position on a particular date.  This position will change when each transaction hit the accounts.

The Process Till Balance sheet

Practically, The accounting process starts when we get the invoices or source documents relating to the transactions. We analyse the transactions based on the source document, then record in the journal. These journals will be verified by the  Accounting Supervisor, then approve and post to the Ledger. At the end of the period, we can make a report by drawing the balances of all the accounts, which is called Trial Balance. After the adjustment, we can prepare the P&L account by taking all the nominal account balances. The balance sheet is preparing with the asset and liabilities account balances.

Who Needs to understand the Balance sheet

Many people need to read and understand the balance sheet of the business. Each group of people have a different objective to understand the balance sheet. The main group pf people are

Owners

Owners of the business need to understand the balance sheet to know the position of their capital. It helps them to identify the liquidity, growth and earning capacity, of the business. Owners may be the small business owners or shareholders in case of corporations.

Creditors

Creditors need to understand the balance sheet to evaluate the creditworthiness of the business. It helps them to decide whether to enter the credit agreement with the business or not. Creditors evaluate the balance sheet of the business, even when increasing the credit limit.

Government Authorities

Tax Authorities and other corporate affairs department of the country may be interested to see the balance sheet of the company. Tax Authorities need it mainly for assessing the tax. Other government agencies and to evaluate the balance sheet to verify whether the business complies with the norms and guidelines issued by the government from time to time.

Employees

Employees also interested to understand the financial position of the company. It may be for demanding an increased pay hike or bonus. Some companies are giving Employee Stock Option to its employees. So they need to understand the balance sheet and its changes from year to year. It also helps the employees to have an idea about their future in the company.

Members of the Managemen

Members of the Management team needs to understand the balance sheet to plan the strategic decision of the firm. Many analysis is available to summarize and understand the content of the balance sheet to help the management.

How to Prepare the  Balance sheet

The balance sheet prepared based on the Trial Balance of the Company. All the nominal Account figures are taking into the Profit & Loss Account, and all the assets and liabilities account balances are taking to the Balance sheet.

The small business follows a simple style presented in two columns.
There may be some regulatory requirement for companies to follow a specified format, depending on the size, nature and the geographical area.

understand the balance sheet

To understand the balance sheet, we need to know the terms used in the balance sheet.

For a small business, it is a little bit easy to understand what the items representing in the balance sheet. Usually, a balance sheet has two sides. One side is lited with all the assets. These assets have different nature like the fixed asset, current assets, tangible assets etc. The other side listed with all the liabilities. These liabilities include Capital, long term liabilities, current liabilities etc.

Both assets and liabilities are equal because of the balance sheet equation. The equation is

Asset = Liabilities
Asset = Liabilities + Capital (Owners Equity)

So if there is any change in the total of assets, it will also affect the liabilities with the same amount.

Items in the Asset side of the Balance sheet

1. Assets

Assets are the properties that the business owns. It also includes the advances paid for future benefits like Prepaid Insurance Premium, Prepaid Rent etc.
These assets have classified as Fixes Assets and Current Assets. It is also known as Non -Current Assets.

Read: Depreciation Accounting

Fixed Assets or Non -Current Assets

Fixed Assets or Non -current Assets are the resources or properties owned by the business. These assets are using for the production or renting services to earn profit in the future.
Examples of the fixed Assets are Land, Plant and Machinery, Building, Goodwill, Investment and financial assets etc.

Current Assets

Assets are termed as current assets if these assets are realised or consumed in the normal operating cycle. All these assets are mainly for trade purpose only.
It includes inventories, Trade Receivables, Cash and Cash Equivalents, Cash at the bank, short term loan and advances etc.

2. Liabilities

Liabilities means the obligation of the business to others. It includes the responsibility of business toward the investors. These obligations mainly used to fund the assets of the company. Liabilities side of the balance sheet shows shareholders fund, Share application money pending on the allotment, Non -current liabilities and current liabilities.

Share Capita

Share Capital includes the owners’ investment or equity capital of investors

Reserve and Surplus

Reserve and Surplus also include in the liabilities side of the balance sheet. This head usually found in big companies. Small companies will add this amount to the capital accounts. When a business earns profit, it allocates a portion of its profits to the reserves

Non-current Liabilities or Long term Liabilities

Non-current Liabilities or Long term Liabilities considered as important components of liabilities side of the balance sheet. The business may have some obligations or liabilities which need to settle in along period. These liabilities include bank loan and other secured loans.

Current Liabilities

Current Liabilities means the liabilities need to settle within the twelve-month after its reporting. It includes the short term borrowings, Trade payables, Other current liabilities and short term provisions.

Big companies using a different style of format which shows below.

These are the main points to discuss to understand the balance sheet. To have a clear idea, one must get trained the double-entry bookkeeping and accountancy. So the investors wish to understand the balance sheet, can attain this specific knowledge through certificate courses. I hope you enjoyed this article. Please do not hesitate to comment below, if you feel I missed any topic or need any clarification or details.

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