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Understanding Balance Sheets: A Beginner’s Guide

An accountant preparing a balance sheet.
An accountant preparing a balance sheet.

A balance sheet is a financial statement that shows a company’s resources (assets) and how they were financed at a given time period, either through debt (liabilities) or equity contributions from owners/shareholders. It is also known as the Statement of Financial Position.

It can be implied with this structure: Asset = Liabilities + Equity

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Why is the Balance Sheet Important?

A balance sheet shows a company’s financial position over a certain period. It provides data that can be useful in tracking the performance of the business.

What are the Benefits of the Balance Sheet? Who uses a Balance Sheet?

To Owners: 

  • It provides a snapshot of the company’s finances. It shows the company’s assets (cash, receivables, and prepayments) and liabilities (debt). It also displays the cumulative Income/ Loss and the contributions of the owner/ investors. 

To Investors/Shareholders:

  • It explains where their money will go, whether it will be spent on operations or used to pay off the company’s debt. It will also provide a summary of the company’s finances at a specific point in time. 
  • Future investors can use this report to decide whether or not to invest, as it shows the company’s financial health and how it operates.

To Tax Preparers:

  • It appears on Schedule L of a C corporation’s tax return. 

Other Uses of the Balance Sheet

  • It can immediately determine whether your assets can cover your liabilities.
  • In the event of dissolution, it provides information about how much stockholders/owners can retain after paying all of their liabilities.
  • It also influences the decision to distribute dividends to stockholders.
  • If assets exceed liabilities, the company’s financial health improves because assets add value to the business.

What Type of Companies Does This Apply To? 

The balance sheet is applicable to all companies; the only difference is the chart of accounts used. As companies are in different industries, for example, a manufacturing company may use accounts like packaging costs while a service company does not.

Read More: Understanding the Cash Flow Statement: An Overview of Key Concepts

Definition of each term appearing in the balance sheet

TermDefinition
Current AssetsThe company resources that can be liquidated, converted into cash, or used within 12 months from the balance sheet date.
Bank AccountDisplays the balance of your bank accounts on the balance sheet date.
Debit/ Savings/ Current – appears as Current Assets, while Credit Card Accounts are presented as current liabilities.
Cash on Hand Money that has yet to be deposited; sometimes, businesses keep cash on hand to serve as a change to customers.
Receivables Accounts that are collectible from customers with sales invoices (usually for goods that were delivered and/or services that were already rendered) are expected to be collected within 12 months from the balance sheet date. 
Prepayments Paid services, taxes, or goods in advance. Sample – estimated quarterly tax.
Non-current AssetsResources that cannot easily be converted to cash within 12 months from the date of the balance sheet.
Fixed assetsInclude equipment (office, computer), buildings, machinery, furniture, and fixtures; these cannot be easily converted into cash and must be depreciated (cost spread over useful life), which can be costly.
Accumulated Depreciation In theory, this is the amount of fixed assets that were already expensed or credited against income.
Software Development Costs incurred in developing software for use by the company.
Accumulated AmortizationRefers to software development costs that have already been expensed or credited against income. Typically, software development costs are amortized over its useful life. (Or if US company – 5 years (if US made) / 15 years (non-US made), whichever is lower).
Current LiabilitiesA company’s financial obligations that must be paid within 12 months from the balance sheet date.
Accounts Payable The money owed to vendors for services or goods received and due within 12 months.
Income Tax PayableThe amount owed by the company to the government.
Accrued Expenses Expenses that have already been incurred but not yet paid, like interest expenses (loan interest is sometimes paid in full along with the principal at the end of the term).
Non-current LiabilitiesFinancial obligations that are due to be paid more than 12 months from the balance sheet date.
Notes Payable Obligations that are evidenced by promissory notes issued to financiers (banks or any other financial institutions), and they are expected to be paid in the long term. If the note payable is to be settled in full in less than 12 months, it is presented among the current liabilities.
Simple Agreement for Future Equity (SAFE)One way in which a company raises money. They are considered debt but do not have interest. If the shareholders do not succeed, they have to pay back the money plus interest if it’s not converted to equity. 
Common / Preferred Stock Record the number of stocks issued by the company multiplied by the par value of the shares issued.
Addition Paid in Capital (APIC)Excess contributions made by the stockholders from the par value of the stocks.
Example: B paid $10,000 for 1,000,000 common stock of Company A. Company A stock has a par value of 0.00001. Common Stock will be recorded as (1000000* 0.00001) = $10 and APIC is $10000-$10 = $9990. 
Owner’s Contribution Records all the owner’s contributions to the company for its operation.
Net Income for the YearThis is the result of operations where the total revenues and gains exceeded the aggregate expenses and losses for a period of time.
Retained Earnings Records all the net income or loss of the company, including dividends declared and adjustments to prior period errors since incorporation.

NOTE: Accounts Receivable, payables (accounts and notes), prepayments, and Accrued expenses are only applicable to the accrual basis of accounting.

Author Bio
David McKeegan
David McKeegan, the founder of Cleer.Tax is both an MBA and Enrolled Agent. As an entrepreneur and small business owner himself, he really understands the pain points that company owners and founders have in regards to tax compliance and having clean financial statements. What really differentiates David is his ability to distill complicated tax matters into layman’s terms, making the advice actionable and accessible to all.
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