How to read a balance sheet

business.gov.au describes the balance sheet as a picture of the financial health of a business at a given moment in time. It lists everything the business owns, its assets, and everything it owes, its liabilities, and from those works out its net assets.

Because it describes one date, a balance sheet is usually prepared for the last day of a month or of the financial year, which in Australia ends on 30 June.

Assets are split into two groups.

• Current assets are cash and assets the business expects to sell, collect or use up within a year, or within its normal operating cycle if that is longer, such as petty cash, money owed by customers, inventory and prepaid expenses. Prepaid expenses are used up as the business receives what it paid for, rather than turning back into cash.
• Non-current assets are the assets the business keeps for longer. The most familiar are fixed assets, which business.gov.au describes as long-term assets the business owns and uses in its operations, such as leasehold, property and land, vehicles, equipment and tools, and furniture and renovations.

Adding the two gives total assets.

• Current liabilities are obligations the business expects to settle in its normal operating cycle or that fall due within 12 months, such as credit cards, accounts payable, interest payable and wages that have been earned but not yet paid.
• Long-term liabilities are due after a year or more, such as loans.

Adding the two gives total liabilities.

Net assets are total assets minus total liabilities. business.gov.au notes they are also known as net worth, owner's equity or shareholders' equity. If net assets grow from one balance sheet to the next, the business has kept more value than it has taken out or lost.

business.gov.au says a balance sheet can help you work out your working capital, the money needed to fund day-to-day operations, and your liquidity, which is how quickly you could pay your current debts.

The usual measure of working capital is current assets minus current liabilities. In the example above that is 18,500.00 minus 9,300.00, or 9,200.00. A positive figure means current assets exceed current liabilities. It does not by itself show that enough cash will be available when each bill falls due.

A single balance sheet is a snapshot. Comparing it with the same date a year earlier shows whether debts are growing faster than assets, whether cash is building up or running down, and whether net assets are rising.

Read it alongside the profit and loss statement, which shows how the business performed over the period, and the cash flow statement, which shows how its cash moved.

The summary above shows only totals. A working balance sheet lists each account, and it tells you far more with the same date a year earlier printed beside it. The example below belongs to a small joinery business run as a company, so its equity is split into share capital and retained earnings.

Start with cash. The bank balance fell from 14,800.00 to 3,900.00, while petty cash stayed at its float of 200.00. A drop like that is the first thing to explain, and the lines beneath it usually do.

Accounts receivable, the money customers owe, more than doubled. Either sales grew or customers are taking longer to pay, and an aged receivables report will show which. Inventory rose by 8,100.00, so more timber and hardware is sitting in the workshop waiting to become jobs. Prepaid expenses barely moved: this is insurance or rent paid in advance, which the business will use up rather than turn back into cash.

Equipment and tools went up by 13,000.00, which points to a purchase during the year. Vehicles went down, because the recorded value of a vehicle usually falls as it ages. How that fall is worked out each year is for your accountant to set.

On the other side, every current liability grew. The credit card balance more than doubled, accounts payable rose by 6,300.00, and an overdraft appeared that wasn't there a year ago: the cheque account still holds 3,900.00, but a second account with an overdraft facility has been drawn 5,500.00 below zero. The business loan grew by 9,000.00, which paid for most of the new equipment.

Working capital fell from 27,300.00 to 17,500.00. It is still positive, but more than half of current assets is now stock. Leave inventory and prepaid expenses aside and the assets that can become cash soon add up to 15,700.00, against 23,300.00 falling due within the year.

Net assets fell from 51,300.00 to 41,500.00, and with share capital unchanged, the whole fall shows up in retained earnings. Either the year made a loss or more was paid out to the owners than the year earned. The profit and loss statement for the year will tell you which.

A balance sheet balances because its two halves are the same equation: assets equal liabilities plus equity. Everything the business holds was funded either by money it owes someone else or by value that belongs to its owners. business.gov.au's glossary works the equation from the other end, describing equity as assets with liabilities deducted.

Double-entry bookkeeping keeps the halves equal. business.gov.au describes it as recording each transaction in 2 accounts, once as a debit and once as a credit. Buy 2,000.00 of timber on account and inventory rises by 2,000.00 while accounts payable rises by the same amount. Pay that supplier and cash and accounts payable both fall by 2,000.00. Every entry either moves both halves by the same amount or shifts an amount within one half, such as cash turning into stock.

The report itself shows balances rather than debits and credits. Behind it, asset accounts normally hold debit balances, and liability and equity accounts normally hold credit balances. That is why a trial balance whose debits equal its credits produces a balance sheet that balances, once the period's profit or loss is counted in equity.

If a balance sheet you have built in a spreadsheet won't balance, look for an account left out, a missing opening balance, a figure typed on the wrong side, or the current period's profit not yet added to equity. Accounting software posts both sides of every entry, so its balance sheet balances by design. There, look instead for amounts parked in a suspense or uncategorised account, which can make a balance sheet balance while still being wrong.

Before you read meaning into a balance sheet, check that its main balances agree with documents and counts from outside the books, or with the detailed lists that sit behind them. This is what people usually mean by a balance sheet reconciliation, and it takes less time than chasing a trend that turns out to be a bookkeeping error.

• Cash at bank: the closing balance on each bank statement for the same date, after allowing for deposits and payments that haven't cleared. business.gov.au's glossary calls this cross-check a bank reconciliation.
• Accounts receivable and accounts payable: the totals of your customer and supplier lists for the same date. If they differ, look for an entry posted straight to the balance sheet account rather than to a customer or supplier.
• Loans, overdrafts and credit cards: the lender's or card provider's statement for the same date.
• Inventory: your latest stock count, valued the way your accountant has set.
• Petty cash: a count of the cash in the tin, plus receipts for what has been spent from it.

If a balance doesn't agree, the balance sheet isn't ready to read yet. Find out why: correct any error in the books, and raise any error on a statement with the bank or lender, then come back to the comparisons.

business.gov.au's financial health check lists the amount of existing debt and periods of high or low cash flow among the things to watch. On a balance sheet they show up as a handful of patterns, and several appear in the joinery example above.

• Cash falling while accounts receivable and inventory rise. Money is being tied up in unpaid invoices and stock instead of reaching the bank.
• Current liabilities growing faster than current assets. In the example they more than doubled, while current assets rose by 3,800.00.
• Accounts payable climbing from one balance sheet to the next. Unless purchases grew by as much, suppliers are being paid later. business.gov.au names delaying supplier payments, relying on credit and struggling to pay bills as signs that cash flow is under pressure.
• A new or growing overdraft, or a card balance that keeps climbing. Short-term borrowing that covers everyday bills is a different thing from a loan taken out to buy equipment, and business.gov.au counts relying on borrowed funds to keep operating among the signs of poor profitability.
• Net assets falling year after year. Each fall means the owners' stake in the business, as the books record it, is smaller than it was.
• Net assets below zero, where liabilities are larger than assets. The next section covers what that means.

One sign on its own may have a simple reason, such as stock bought ahead of a busy season. Several together are worth raising with your accountant, and business.gov.au suggests getting professional help early, before financial problems grow.

Yes. Three negative figures are worth knowing, and each means something different.

• Negative net assets: total liabilities are larger than total assets. Because equity is assets with liabilities deducted, total equity is negative as well. If the business sold everything at the values shown, it could not pay all its debts. A balance sheet like this is one to discuss with your accountant straight away. business.gov.au's glossary describes a business as insolvent if it cannot pay its debts when they are due, so the cash flow forecast matters as much as this figure.
• Negative retained earnings: the company's profits since it started, less its losses and what it has paid out to its owners, come to less than zero. The figure is often labelled accumulated losses, and it can happen in a company's first years of trading.
• Negative cash: a bank account drawn below zero, which business.gov.au's glossary calls an overdrawn account. Money owed to the bank is a liability, so it is usually shown with current liabilities rather than as a minus figure among the assets. A negative cash balance can also mean the books are behind the bank, with a deposit not yet entered or a payment entered twice, so reconcile the account before drawing any conclusion.

As often as your books are up to date, because a balance sheet can be produced for any date. business.gov.au suggests reviewing your main financial documents, the balance sheet among them, regularly, and giving the business a fuller financial health check at least once a year.

Reading one at the end of each month, after the bank accounts are reconciled, lets you catch a trend while there is still time to act on it. Compare it with the previous month as well as the same month a year earlier, so a seasonal swing isn't mistaken for a problem. Stock may build before a busy period, and accounts payable can jump after a large delivery, so a single month can look better or worse than the year as a whole.

A lender may want a recent balance sheet too: business.gov.au lists financial reports among the paperwork a business loan application may need. Keep each balance sheet you produce with the reconciliations behind it. business.gov.au says most business records must be kept for 5 years from when you got them or completed the transactions they relate to, whichever is later, and company records for 7.