There are 12 reasons why balance sheet is important for your business.
A local trader recently asked me “what is balance sheet”?
I have hardly answered the question when yet another trader nearby asked me “how can a sheet balance”?
As ridiculous as the questions were, they deserve answers because of people who are not coming from the accounting background.
The balance sheet is one of the three most important parts of annual financial statements which you are expected to prepare for your business at the end of every year.
It is called balance sheet because it is a collection of the balances in all the various accounting books and records of your business.
Essentially, it’s purpose is to show the assets (properties) owned by your business at any given period of time.
On the flip side, balance sheet will show all the liabilities (debts) owed by your business at the end of a given period of time.
The reason why both sides of the statement must be equal is that in accounting, “any item with a debit entry must have a corresponding credit entry”.
Furthermore, it shows lenders whether you have over borrowed money or whether you have the capacity to pay back loans if granted to your business.
This article is intended to help you read, interpret and understand how how balance sheet can help you in decision making.
Balance sheet date
This is the last working day of the period for which you are preparing financial statements.
It is the date on which all accounting books and records of your business are closed or ruled off.
Thus, it signals the end of your business activities for the year.
Furthermore, it also means that you are now ready to prepare your accounts for the year.
Many companies all over the world close their accounting books on December 31 each year.
A variant of this is that you can prepare it monthly, quarterly, half yearly or yearly, depending on the needs of your business.
The Companies Act And Allied Matters Act approved two methods for presenting company balance sheet.
They are the horizontal format and the vertical method.
This method which is also called the “T” format, is mainly used by students who are studying principles of accounts or elementary bookkeeping.
In this method, your assets [properties] will be shown on the left hand side of T account.
And the liabilities [debts] and the capital of your business will be shown on the right hand side of the T account.
The vertical method is the format most commonly used by companies for presenting balance sheet.
It is thought that the reason for this preference is that it is more convenient and easier to prepare and use than the T method.
However, at the end of the day, both methods show the same information.
Balance sheet items
Fixed assets are the equipment that you use to generate revenue in your business.
The items you can find in it will typically depend on the industry you belong to.
For example, a bank balance sheet can contain many items that you can never find in that of a trading company.
However, there are many assets and liabilities items that are common to all balance sheets.
Typically, the balance sheet will contain assets, such as:
- Freehold land and buildings
- Motor vehicles
- Plant and machinery
- Computer equipment and accessories
- Furniture, fittings and equipment, etc.
- Cash in hand
- Balance at bank
- And lots more.
The current liabilities will contain, among others:
- Bank loans/overdrafts
- Accrued business expenses
- Taxes not yet paid
- Unpaid dividends and
- Lots more.
The statement will show the amount of money that you invested in the business.
Furthermore, if you make a profit during the year, it will be added to the capital you invested, thereby increasing the net worth of your business.
On the other hand, if you traded at a loss, the amount will be deducted from your capital.
Importance of balance sheet
The balance sheet is very important for your business for various reasons.
Firstly, it will help you to know the financial position of your business.
Secondly, it can also help you to monitor and track some items in your business.
For instance, you can know through your capital account whether or not your business is growing.
Thirdly, it will be very easy for you to know how much cash you have in hand and the balance in the bank.
Fourthly, you will be able to know how much debt your business is owe to suppliers, banks or other lenders.
Similarly, the statement will show how much of your business money is in the hands of your customers.
This will enable you to plan how and when you can go on debt drive.
This statement will present you with some vital stats that you may need to make informed decisions that can move your business to the next level.
For example, you will be able to know whether you:
- Have locked up too much of your business capital in fixed assets
- Have insufficient working capital
- Are having liquidity problems.
- Assets utilization efficiency problems
It will provide information that can help you to calculate important ratios that:
- Investors and lenders will need to look at when you approach them to fund your business.
- Examples are quick ratio, working capital ratio, debt to equity ratio and so on.
- Should you need to sell the business, negotiation will be straightforward because both of you are looking at the numbers.
- Should fire or any other natural disaster strike your business, you can easily download a copy of the balance sheet from the internet.
- The tax authorities or insurance companies may have need to look at your balance sheet.
Finally, some of the most important areas to pay attention to are cash, accounts receivables and short term and long-term obligations.
By Samuel Ijenhi,
B.Sc. Accounting, (University of Benin)
Benin City, Nigeria.