The balance sheet is packed with financial information crucial to understanding the health of your company. However, for a lot of people, it’s one of the hardest financial statements to get to grips with.
Even the most fundamental pillar of the balance sheet, “why it needs to balance”, eludes many of us. It’s easy to look up the formula, but not so easy to understand why this formula is the way it is.
It’s actually a lot simpler than you think. Let’s take a look.
What is a balance sheet?
In essence, a balance sheet is a financial report that provides a snapshot of a company’s financial position at a specific point in time. It presents the company’s assets, liabilities, and shareholders’ equity. The balance sheet follows the fundamental accounting equation, which states that assets must equal liabilities plus shareholders’ equity.
To dive deeper into the principles of financial reporting, you can explore the accounting standards from the IFAC for global best practices in balance sheet preparation.
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What does a balance sheet consist of?
The balance sheet is split into two halves. Each half should add up to the total value in the business. The balance sheet formula is below:
Assets = Liabilities + Shareholders’ Equity
The top half (Assets) breaks down how this value is being used in the business.
The bottom half (Liabilities + Equity) breaks down how this value was acquired, i.e. the sources of funding.
The two halves must balance because the overall value of the business’s assets will have been financed through a combination of liabilities and equity. If they aren’t balancing, it can only mean that something has been missed or an error has been made.
Balance sheet assets: what does the company own?
The assets of a balance sheet include everything that could contribute to the value of the business. It can range from the cash in your bank account to the value of equipment you own. You’ll even see the value of money owed to you but not yet received (accounts receivable). This still counts as an asset even though you the cash isn’t with the business just yet.
Balance sheet liabilities: what does the company owe?
Liabilities represent the company’s debts or obligations to external parties. It takes all forms of debt into consideration, such as outstanding loans or tax payments. They are also classified into different categories, current liabilities and long-term liabilities.
- Current liabilities are obligations that are expected to be settled within one year, such as accounts payable or short-term loans
- Long-term liabilities are obligations that are due beyond one year, such as long-term loans
Balance sheet shareholders’ equity
Shareholders’ equity is the remaining value in the company’s assets once liabilities have been deducted. It consists of:
- Share capital: This includes the value of shares issued by the company to shareholders
- Retained earnings: Retained earnings refer to the company’s accumulated profits or losses that have been kept within the business rather than paid out to shareholders as dividends.
- Additional paid-in capital: This represents the amount shareholders have paid for shares that exceeds the share capital
With all of these components in mind, it should be impossible for the balance sheet to ever be unbalanced.
But sometimes it doesn’t balance! Which means something must have gone horribly wrong…
So, what is the rule of a balance sheet?
The fundamental rule of a balance sheet is that total assets must always equal total liabilities plus equity. This equation – Assets = Liabilities + Equity – ensures that every financial transaction is properly recorded, reflecting the true financial position of a business. If the equation doesn’t balance, it indicates an error, such as missing transactions or misclassified accounts. Maintaining this balance is essential for accurate financial reporting, compliance, and informed decision-making.
How to read a balance sheet
A balance sheet provides a snapshot of a company’s financial position, but understanding what the numbers mean is key. Start by checking if total assets equal total liabilities plus equity – any imbalance signals an error.
Next, analyse current vs. long-term assets and liabilities to assess liquidity and debt obligations. Look at equity changes over time to gauge business growth. Financial ratios like the current ratio (current assets ÷ current liabilities) help determine short-term stability, while the debt-to-equity ratio (total debt ÷ total equity) shows financial leverage.
Regularly reviewing these elements helps businesses make informed financial decisions and plan for the future. For more resources on reading balance sheets and financial reports, you can also visit AICPA’s financial reporting page.
What could cause a balance sheet not to balance?
For a balance sheet not to balance, there must be an error somewhere in the report. This can either be human or a software error:
Data entry errors
Incorrect recordings of financial data can lead to imbalances in the balance sheet. Simple mistakes, such as entering the wrong numbers or misplacing decimal points, can result in assets not equalling liabilities plus shareholders’ equity.
Omissions or missing transactions
If certain transactions or items are not included in the balance sheet, it can cause an imbalance. For example, if a transaction is mistakenly omitted or a particular liability or asset is overlooked, the balance sheet will not reflect the accurate financial position.
Timing differences
If transactions occur at different times but are not accounted for properly, it can cause an imbalance. For instance, if an expense is recognized in one accounting period but the corresponding payable is recorded in the subsequent period, it can disrupt the balance sheet balance.
Reconciling items
Certain items may require adjustments or reconciliation between different financial statements, leading to temporary imbalances. A common example of this is differences in foreign currency translation, which can cause the balance sheet to be temporarily out of balance until the correct adjustments are made.
Complex financial instruments
In some cases, complex financial instruments or arrangements, such as derivatives or structured products, may introduce complexities in determining their fair values or accounting treatment. This can result in difficulties in accurately reflecting these items on the balance sheet, potentially causing imbalances.
When a balance sheet does not balance, it is important to thoroughly review the financial records, investigate potential errors, and reconcile any discrepancies. Such issues can impact the reliability of the financial statements and may require adjustments or corrections to ensure accurate reporting.
What happens if a balance sheet doesn’t balance?
If a balance sheet doesn’t balance, it signals an error in financial reporting that needs immediate attention. Common causes include data entry mistakes, missing transactions, or misclassified accounts. An unbalanced balance sheet can misrepresent a company’s financial health, leading to incorrect decisions and compliance issues. To fix it, review journal entries, check for omissions, and ensure assets always equal liabilities plus equity. Using financial modelling tools like Brixx can help identify discrepancies and maintain accurate records.
Making a start on your balance sheet
Looking at the two halves of the balance sheet is like looking at two sides of the same coin. The top half and the bottom half break down the same figure: the total value of the business. It should always balance because every transaction impacts both sides – showing where the money came from and how it’s being used.
If the double-entry accounting process is followed correctly, the balance sheet will always balance. If it doesn’t, an error has likely occurred somewhere along the way. Understanding this fundamental principle makes it easier to analyse this key report.
To make managing and forecasting your balance sheet even easier, get started with Brixx. With Brixx’s powerful financial modelling tools, you can easily track your assets, liabilities, and equity, ensuring your balance sheet always stays accurate and aligned with your business goals.
Further information on your balance sheet
A balance sheet example
Let’s say you have £10,000 sitting in your bank account. This is classed as an asset, so it sits on the top half of the balance sheet.
On the bottom half, we have two activities happening:
- A loan of £5,000 that we need to pay back (a liability).
- Retained profit (money earned by the business in a previous period) of £5,000 (equity).
In this simple example, there’s £10,000 in the bank, which came from a combination of a £5,000 loan and £5,000 worth of profit from the last month.
So, the assets show where the value in the business is (your bank account), and the bottom half shows where it came from (the loan and past profits). The balance sheet balances because both halves account for the same money.
This can get more complex in a full balance sheet where the value is split across various assets (e.g., inventory, property, equipment), and liabilities can include multiple debts, loans, or obligations. However, the principle remains the same due to double-entry accounting. Every transaction gets recorded in at least two places to ensure the balance sheet stays balanced.
| Balance Sheet Example | Amount (£) |
|---|---|
| Assets (What the business owns) | |
| Cash (Bank Account) | £10,000 |
| Liabilities & Equity (Where the money came from) | |
| Loan | £5,000 |
| Retained Profit | £5,000 |
| Total Liabilities + Equity | £10,000 |
