As a small business, tracking your finances is incredibly important. Not only does it help you understand your business’s financial situation, but when you’re ready to apply for a loan, having accurate and updated financial records will help lenders better understand your story.
There are several key documents to maintain, and in this article you’ll learn all about your balance sheet. Learn about the most important elements of your balance sheet and why they matter to a lender.
What is a balance sheet?
A balance sheet represents your business’s assets, liabilities, and equity at a given point in time. Essentially, it reflects what your business owns and owes. The basic equation for a balance sheet is:
Total assets = Total liabilities + Equity
Your balance sheet is a snapshot of your business at a specific point in time. For every asset you report, there must be a corresponding liability or equity. For example, if you purchase a piece of equipment for $25,000, the funding of this asset must have come from a liability, equity, or a combination of both.
What are key elements of a balance sheet?
1. Assets, liabilities, and current ratio
Assets are everything that your business owns. There are two types of assets:
- Current assets:
Assets that can easily be converted to cash, such as inventory and accounts receivable
- Fixed assets:
Assets that are not as easily converted to cash, such as equipment and other fixtures.
On the other hand, liabilities are everything that your business owes. There are two types of liabilities:
- Current liabilities:
Liabilities that must be paid within one year, such as accounts payable, credit cards, lines of credit and taxes payable
- Long-term liabilities:
Liabilities that must be repaid over the course of several years, including equipment loans, and term debt. Many COVID relief loans fall into this category.
You can assess your business’s liquidity using the current ratio:
Current assets ÷ Current liabilities = Current ratio.
The current ratio is a quick assessment of your business’s cash flow in the coming 12 months, how liquid you are, and whether you’ll be able to pay back your debt. A ratio of more than 1.0 indicates that your business has enough cash and other short-term assets that can be turned into cash to pay any debts you owe to vendors, creditors, and/or lenders in the coming 12 months.
Knowing your assets and liabilities at any given point in time tells you what you’ve spent your money on, and more importantly, where future cash flow is headed. You can forecast your business’s liquidity for the next 12 months by looking at changes in current assets. And you can see how much of your liquidity will be needed to pay back creditors by looking at changes in current liabilities.
Your current ratio is one of the key things a lender looks at for your balance sheet. The high your ratio is above 1.0, the more cushion the lender sees to cover all your short-term liabilities.
2. Equity and retained earnings
Equity is what’s left after subtracting your liabilities from your assets. It can be broken down into money that was invested in the business by you (for example, stock or paid-in capital) and any money that has reinvested or kept in the business, such as retained earnings.
Retained earnings are calculated by adding all your profits generated over the years, then subtracting all cash distributions taken out of your business by you and your other owners.
Lenders see the equity reported on your balance sheet as a reflection of your profitability, and your willingness to invest and reinvest in your business. A positive equity figure shows that your business has more assets than liabilities, which demonstrates your liquidity.
However, if your business is losing money it can also show positive equity figure if you keep investing in your business. This is why lenders look more closely at your retained earnings. When your retained earnings are negative, lenders will see that you’ve has lost more than you’ve made, or that you and other owners have taken more distributions than you’ve earned in profits. In both cases, lenders will see this as a warning sign of a distressed business.
3. The leverage (debt/worth) ratio
Another key balance sheet figure is the leverage ratio, also known as the debt/net worth ratio. Here’s how you calculate this ratio:
Total debt ÷ Total equity = Debt/Net worth ratio.
Leverage shows how you use other people’s money to fund the operations of your business. A leverage ratio of 1.0 shows a perfect balance between your debt and your equity.
It’s important to watch your leverage ratio to maintain a healthy balance between your use of debt and equity. Taking on high levels of debt can make it harder for you to repay it, so you’ll want to aim for a lower leverage ratio. Your leverage ratio can fluctuate over time, so make sure you’re familiar with your numbers and know how they balance out.
Lenders will do a quick assessment of your risk by looking at the leverage ratio for your business. While a lower ratio is preferred, a lender will compare your business’s ratio to others in your industry and similar sized businesses to determine if it’s appropriate. Some traditional lenders have thresholds for the maximum leverage they will accept, while alternative lenders may make decisions on a case-by-case basis.
A balance sheet is the road map to what your business owns, and how it funds these assets. Since the balance sheet is a just snapshot in time, it is important to watch for changes over time. If you need funding or support, you can turn to Pursuit. We can help you find the financing you need and connect you with business experts to help you grow.