How to read a balance sheet (A simple guide for beginners)

Startup life is all about balance - and not just the kind where you're dodging your cat on the way to a Zoom call. As a founder, you’ve got a lot to juggle. But one thing you absolutely can’t ignore is your company’s finances. As we always say, you have to know your numbers. A great way to start is by learning how to read a balance sheet.

It’s easy to overlook finances when you’ve handed them off to someone else. However, we strongly suggest learning the basics to stay informed.

As surprising as it may sound, understanding a balance sheet is like holding a secret map. Those numbers that sometimes seem arbitrary are actually important clues. They can guide you toward smarter decisions and more success.

Key takeaways

• A balance sheet is a "financial selfie" that provides a snapshot of your company’s assets, liabilities, and equity at a specific point in time.

• The balance sheet equation (Assets = Liabilities + Equity) must always balance.

• A healthy mix of current and non-current assets, as well as well-managed liabilities, is key to maintaining your startup.

• Balance sheets guide smarter spending and financial decisions by revealing past trends and helping plan for the future.

• You can forecast revenues, expenses, and net income to build a projected balance sheet.

• For complete financial insights, pair the balance sheet with income and cash flow statements.
  

Table of contents

• What is a balance sheet?
• So, how exactly do you read a balance sheet?
• How to use your balance sheet
• How to create a balance sheet forecast
• Use your balance sheet along with your other financial statements
• FAQs
  

What is a balance sheet?

A balance sheet is like a quick snapshot of your company’s finances. Think of it as a financial selfie taken at a specific moment. It clearly shows what your business owns and what it owes (assets and liabilities). Plus, it highlights the owner's stake in the company (equity).

So, how exactly do you read a balance sheet?

The basic accounting equation says: Assets = Liabilities + Equity. At first, learning how to read a balance sheet might feel overwhelming. It’s especially true if you’re not a numbers person. In this post, we break down the process to make it a cinch for anyone to decipher balance sheets like a pro.

1. Know your ingredients

Step one is knowing what the balance sheet equation means. Let's start with assets.

1. Assets: Assets represent everything your company owns with value: things like cash, equipment, and money people owe you. They're usually listed from most liquid to least liquid, where liquid assets are things you can easily turn into cash.
2. Liabilities: Next up are liabilities. These are what your company owes to others. Think about loans, unpaid bills, or employee salaries. Liabilities are essentially money you’ll need to pay in the future.
3. Equity: Finally, we have equity. Equity is the owner's share of the company. It’s what remains after subtracting liabilities from assets. For startups, this usually includes common stock, retained earnings, and extra paid-in capital.

2. Understand the recipe

Assets - Liabilities = Equity. This simple equation shows how your business’s finances work. Equity grows when your business earns a profit. On the other hand, it shrinks when your business loses money.

The equation must always stay balanced. That’s why it’s called the balance sheet. If your business gains more assets, like cash or new equipment, something must change to balance it out. You’ll either increase liabilities, like taking on loans or grow equity, like raising more capital.

3. Check the assets section

Let’s start by grabbing a balance sheet and taking a look. To make it feel less overwhelming, we’ll create a simple example. Let’s focus on the assets section first. This will make it easier to understand the numbers. With a clear scenario, it won’t feel so intimidating!

Identify current assets and non-current assets

Let’s imagine that you're a superhero, kind of like Batman, but for the financial world. Let's call you Forecastman. To tackle challenges and save the day, you rely on your trusty tools - YOUR ASSETS!

Assets come in all shapes and sizes, just like Batman’s devices. These can be divided into two main groups: current and non-current. Each group plays an important role in your financial mission. 

1. Current assets: Current assets are like the tools you use most often, quick and efficient. You can think of them as your Batarangs, Batmobile, or even your well-trained ninja skills. They help you deal with situations fast and keep things running smoothly.
   
   In the real world (away from Gotham), your current assets are the cash, customer promises (accounts receivable), and inventory. These are the things that help you cover short-term needs, like paying bills or handling daily expenses. Having a solid stock of these assets means your startup can quickly handle any financial bumps along the way.
   
2. Non-current assets: Non-current assets may not be as quick to turn into cash as current assets. But they’re like the backbone of your business, the reliable sidekicks that support you for the long haul. These solid foundations keep your company running smoothly and help it grow over time.
   
   You can think of them as your company’s secret weapons. They include your property, equipment, intangible assets like patents and trademarks, and even long-term investments. All these assets work quietly in the background to build your success.

Check the composition

When reviewing a company’s value, it’s essential to know how much is in current assets versus non-current assets. Balancing these two types of assets is crucial for financial health. You don’t want to stock your Batcave with too many Batarangs, right?

If a company has too much in current assets, it might be overly focused on short-term liquidity. This could mean it’s not investing enough in its long-term future. However, if too much value is tied up in non-current assets, it might show a focus on long-term growth at the cost of daily operations.

4. Examine the liabilities section

Identify current liabilities vs. non-current liabilities

Liabilities, like assets, are grouped into two types: current and non-current. You can consider them as financial villains in your business story. Because each one needs a different strategy to defeat.

1. Current liabilities: Current liabilities are like chaotic, unpredictable villains, such as Joker or Harley Quinn. These are things like accounts payable, short-term loans, or other debts that need to be handled quickly. If you don’t manage them right away, they can cause a lot of trouble. So, it’s important to act fast and keep them under control to protect your financial stability.
2. Non-current liabilities: Non-current liabilities, on the other hand, are like the more patient but equally dangerous villains (such as Bane or Ra’s al Ghul). These include mortgages, bonds, or long-term loans that may not feel urgent right now. But if you ignore them, they can grow into bigger threats. You’ll need a solid, long-term plan to handle these, or risk finding yourself dangling over a financial pit of despair later.

b. Evaluate the company's debt load

As mentioned above, every part of a balance sheet matters, and keeping things balanced is key. If current liabilities are much higher than current assets, it might mean trouble paying short-term bills. On the other hand, having too many non-current liabilities could show long-term financial commitments.

Two helpful ratios to keep an eye on are the current ratio and the debt-to-equity ratio.

1.    Current ratio: It helps you check your short-term financial health. You can think of it as your business’s pulse, which ensures steady cash flow. If your ratio is above 1, you’re in good shape to pay off short-term debts. But a very high ratio could mean you’re not using your assets wisely. On the other hand, a low ratio might be a warning to act quickly.

Current Ratio = Current Assets / Current Liabilities

2.    Debt-to-equity ratio: It’s calculated by dividing total liabilities by total equity. Think of it as a financial thermometer for your company. A high ratio means debt is financing more of your business than equity. This can be risky and might signal trouble ahead. But don’t worry, small changes can really improve the situation.

Debt-to-Equity Ratio = Total Liabilities / Total Equity

5. Review the equity section

In our fun superhero world, equity is like Wayne Enterprises. Without Bruce Wayne’s massive company, Batman couldn’t afford all the toys he uses to fight crime. In the same way, your startup’s equity is the driving force behind growth, funding, and long-term success. It’s the foundation that helps you build, invest, and keep growing. That’s why you can take it as your personal Way(ne) to achieving big dreams.

When it comes to equity, two key things matter.

1. First is shareholder’s equity, which is the leftover value of your company’s assets after paying off liabilities.
2. Second, watch for steady growth in equity because it shows your business is profitable and reinvesting wisely.

6. Taste test for red flags or imbalances

After reviewing the numbers on your balance sheet, it’s time to play detective. Look closely for any red flags or unusual imbalances. For example, are liabilities growing faster than assets, especially short-term ones? Is equity shrinking like it’s been left out too long? Are any numbers looking way off compared to industry standards?

So, take your time and carefully analyze these details. They could be signs of trouble that need fixing.

How to use your balance sheet

So, how do you actually use a balance sheet? Let’s consider a scenario: you’re applying for a loan at the bank. They’ll ask for your balance sheet to check if you’re a safe investment. What are they looking for? YOUR ASSETS!

They want to see how much you own and what can be turned into cash. This helps them decide if you’re a smart bet or a risky gamble. Investors also use the balance sheet to see how financially stable your company is.

A balance sheet isn’t just for securing loans. It’s a smart tool for daily decisions. Thinking about buying shiny new gear for your startup? Before you spend, take a quick look at your balance sheet. Can your assets cover it, or should you wait?

These small but savvy decisions keep your startup running smoothly. Plus, they help your cash flow stay steady and strong.

The balance sheet's three financial superpowers

Now, throughout this whole discussion, you might (or might not) be wondering: does the balance sheet itself have a counterpart in the weird Batman-slash-Forecastman analogy we've crafted? The answer is YES, of course. 

Your balance sheet is Alfred Pennyworth with superpowers. It’s your trusted assistant, always working hard behind the scenes. And it offers valuable insights and keeps everything in order for your business.

1. First, its biggest superpower is helping you check if you have enough cash. Think of it as your own personal butler asking important questions like, “Can you pay your bills? Are you ready to invest in growth?” It keeps you on track with your finances, so you’re always prepared.
2. Second, Balance Sheet Alfred is also like your personal doctor. After a long day battling challenges, it examines your financial health. While it doesn’t fix issues, it points out key things like your debt-to-asset ratio. This way, you know exactly what’s working and what’s not.
3. Third, it’s a crystal ball with a twist - it’s more like a time machine! With balance sheets, you can look at both the past and the future.

Financial past: To look into the past, you just need to compare and review balance sheets from different accounting periods. By comparing balance sheets from various time periods, you can spot trends, patterns, ratios, and changes in financial health (or hygiene). Are you growing steadily, holding your ground, or facing challenges? This "balance sheet time machine" helps you travel through your financial history to find the answers.

Financial future: Now, let’s look ahead. A projected balance sheet is your tool for planning the future. It helps you map out how to spend and save smartly. You can even test if a new strategy will work or just sound good on paper. With this financial superpower, planning becomes both strategic and exciting.

How to create a balance sheet forecast

Creating a projected balance sheet might seem like a tricky task, but don’t worry. With the right steps, you can make financial planning surprisingly simple and stress-free.

• First up, you need to forecast your revenues and expenses. Think of this as planning your superhero missions—analyzing market trends, historical data, and growth assumptions to estimate future revenues. Don’t forget to account for all your expenses, from the cost of goods sold to everyday operating costs. The difference between your projected revenues and expenses will give you the net income, which is the lifeblood of your projected balance sheet.
• After you’ve calculated your projected net income, it’s time to turn your attention to your assets and liabilities. Account for all current and non-current Batarangs and Batcaves!

Once you have all your assets and liabilities ready, it’s time to put together your pro forma balance sheet. Total assets should equal the sum of total liabilities and equity. Next, calculate your equity by adding your projected net income to your existing equity. But don’t forget to account for any planned dividends or withdrawals.

Now ensure everything balances out: total assets should equal the sum of total liabilities and equity. This is the key balance sheet equation that's like having Alfred riding shotgun. It will guide you with a roadmap toward your company's future.

Use your balance sheet along with your other financial statements

Even though balance sheets offer a lot of useful info, they don’t give you the complete financial picture. Alfred on steroids may be tougher than he looks, but he's not all-powerful. 

For example, balance sheets only show the original cost of your assets. They don’t reflect what those assets are worth today. That means some might be worth more or less than the price listed. So, to stay fully informed, keep an eye on both the balance sheet and what’s happening in the market. 

Also, when it comes to balance sheets, a lot can impact the numbers. External things like government loans can affect borrowing rates, and changes in company strategy can throw unexpected challenges into the mix. Finally, learning how to read a balance sheet unlocks just one segment of the holy trinity of financial statements. For the full picture, you’ll need to look at the Income Statement Robin and Cash Flow Statement, too.

By comparing the income statement with the balance sheet, you can see how they relate to things like profits, expenses, and revenue. Adding the cash flow statement gives you even more insight, showing not just what’s owned and owed but also how money is moving through the business.

From numbers to knowledge

Learning how to read a balance sheet helps you understand a company’s financial health. It’s a useful skill that can benefit your business knowledge. To get started, practice by looking at financial statements from different resources (like the Treasury's own publicly available balance sheets). Publicly available balance sheets from your state are also a great place to begin.

Don’t worry if you don’t get everything at first. With each balance sheet you review, you’ll get better at seeing how assets, liabilities, and equity work together. Over time, you’ll start to get the hang of it and unlock a great new skill for success.