How to read a balance sheet

The one equation behind every balance sheet

Assets equal liabilities plus equity, and every entry on the page fits into one of those three groups.

Assets are what the business owns or is owed. Liabilities are what it owes to others. Equity is the owners' stake, the amount left if you sold every asset and paid every debt. The two sides always match, which is why the statement is called a balance sheet. The accounting equation explains the logic.

Unlike a profit and loss statement, which covers a period, the balance sheet captures a single day, such as December 31. Think of it as a photograph, where the P&L is a video.

Assets: what you own and what you are owed

List current assets, which turn to cash within a year, separately from long-term assets such as equipment and vehicles.

Here is a short illustrative balance sheet.

Current assets here are cash, receivables and inventory: $100,000 in total. Long-term assets are the equipment at $60,000, shown after depreciation. See what accumulated depreciation means if that line is new to you.

Order matters. Assets are listed from most liquid to least liquid, with cash at the top, so you can see at a glance how much of the business is easy to turn into spendable money and how much is tied up in things that take time to sell.

Liabilities: what you owe

Current liabilities are due within a year, while long-term liabilities such as multi-year loans are due later.

In the example, payables of $30,000 are current, and the loan of $50,000 is partly current and partly long term. Many statements split the loan: the portion due in the next twelve months is current, the rest long term. Other common liabilities include credit card balances, sales tax payable, payroll taxes owed, deferred revenue and customer deposits.

Read the liabilities for size and for timing. A big number due next month is a different problem than the same number due in five years. The accounts payable guide explains the most common current liability.

Also look for liabilities that do not look like debt. Customer deposits and prepaid orders are obligations to deliver goods or service. Unpaid payroll taxes are a serious liability, since tax authorities collect aggressively. If any of these are growing, plan how you will settle them before they come due.

Equity: what is left for the owners

Equity grows with retained profit and owner contributions and shrinks with losses and owner draws.

In the example, equity is $160,000 minus $80,000, or $80,000. The equity section typically lists owner investment, retained earnings and sometimes current-year profit. If equity is negative, the business owes more than it owns, a serious warning sign.

Equity and cash are not the same. A business can have healthy equity tied up in equipment and receivables, and still struggle to pay this week's bills. That is why the next set of checks matters.

Many owners are surprised to see how small equity is in a young business that took distributions. Taking out more than the business earns steadily drains equity, even if each draw seemed modest at the time.

Ratios that make the numbers useful

Liquidity and leverage ratios turn the balance sheet into quick tests of short-term safety and debt load.

Calculate these from the example.

• Current ratio: current assets divided by current liabilities. With $100,000 of current assets and, say, $40,000 of current liabilities, the ratio is 2.5. Above 1 means you can cover short-term bills on paper.
• Quick ratio: current assets minus inventory, divided by current liabilities. It is stricter because inventory may be slow to turn into cash. See the acid test ratio.
• Debt to equity: total liabilities divided by equity. In the example, 80 over 80 is 1.0. Higher means more reliance on borrowed money. See debt-to-equity.

Healthy levels vary by industry, so compare to your own history and to peers.

Do not treat any ratio as a pass or fail grade. A restaurant with a quick ratio below 1 can be perfectly healthy because customers pay at the table and inventory turns daily. A contractor with the same ratio may be in trouble because customers pay in 60 days. Context decides.

What to watch for, and how it connects to funding

Rising receivables, growing inventory and climbing debt with flat equity are the patterns to catch early.

Compare balance sheets across several dates. Receivables growing faster than sales means customers are paying slower. Inventory piling up ties up cash. Cash shrinking while debt grows can signal trouble. Each of these can happen in a profitable business.

If you are considering outside funding, the balance sheet shows how much debt you already carry and whether new payments are realistic. ROI Funder asks for 3 months of business bank statements with the application, but your own balance sheet helps you decide how much to borrow. Run the loan ROI math first, and see how the three statements fit together.