Understanding Your Balance Sheet: What Every Small Business Owner Should Know

While most business owners focus on the Profit and Loss statement, the balance sheet often gets ignored. That’s a mistake. The balance sheet reveals critical information about your business’s financial health that the P&L can’t show.

If the P&L tells you whether you’re making money, the balance sheet tells you whether you’re building wealth—or digging a hole.

This guide explains the balance sheet in plain language and shows you what to look for.

What Is a Balance Sheet?

A balance sheet shows your business’s financial position at a specific moment in time. It’s a snapshot—not a video—of where things stand.

The fundamental equation:

Assets = Liabilities + Equity

This equation always balances (hence the name). Everything your business owns (assets) was funded by either borrowing (liabilities) or investment/retained earnings (equity).

Think of it this way:

Assets: What you have
Liabilities: What you owe
Equity: What’s left over (what you truly own)

The Three Sections Explained

Assets: What You Have

Assets are everything of value that your business owns or controls.

Current Assets

Assets that are cash or will convert to cash within one year:

Cash and Cash Equivalents: Money in bank accounts, petty cash

Accounts Receivable: Money customers owe you for work completed

Inventory: Products you’ll sell (for product businesses)

Prepaid Expenses: Expenses paid in advance (like insurance premiums)

Short-Term Investments: Money market accounts, CDs maturing within a year

Non-Current (Fixed) Assets

Assets with value beyond one year:

Property, Plant, and Equipment (PP&E): Buildings, vehicles, machinery, computers

Accumulated Depreciation: The value that’s been “used up” (reduces asset value)

Intangible Assets: Patents, trademarks, goodwill

Long-Term Investments: Investments not expected to liquidate within a year

Liabilities: What You Owe

Liabilities are obligations to pay money or provide services.

Current Liabilities

Obligations due within one year:

Accounts Payable: Money you owe vendors for goods/services received

Accrued Expenses: Expenses incurred but not yet paid (wages, taxes, interest)

Short-Term Loans: Notes or credit lines due within a year

Current Portion of Long-Term Debt: Principal payments on loans due this year

Unearned Revenue: Money received for work not yet completed

Sales Tax Payable: Collected sales tax not yet remitted

Payroll Liabilities: Wages and payroll taxes owed

Non-Current Liabilities

Obligations due beyond one year:

Long-Term Debt: Loans, mortgages with repayment beyond a year

Notes Payable: Written promises to pay in the future

Deferred Tax Liabilities: Taxes that will eventually be owed

Equity: What’s Left Over

Equity represents the owner’s stake in the business after all liabilities are paid.

Owner’s Capital/Investment: Money the owner put into the business

Retained Earnings: Accumulated profits not distributed to owners

Owner’s Draws: Money taken out by owners (reduces equity)

Current Year Net Income: Profit from this year (before distribution)

For corporations, you might see:

Common Stock
Preferred Stock
Additional Paid-In Capital
Treasury Stock

Sample Balance Sheet Walkthrough

	Amount
ASSETS

Current Assets
Cash and Cash Equivalents	$45,000
Accounts Receivable	$28,000
Prepaid Expenses	$3,000
Total Current Assets	$76,000

Non-Current Assets
Equipment	$35,000
Less: Accumulated Depreciation	($12,000)
Vehicle	$22,000
Less: Accumulated Depreciation	($8,000)
Total Non-Current Assets	$37,000

TOTAL ASSETS	$113,000

LIABILITIES

Current Liabilities
Accounts Payable	$8,500
Accrued Expenses	$4,200
Credit Card	$3,300
Current Portion - Vehicle Loan	$4,800
Total Current Liabilities	$20,800

Non-Current Liabilities
Vehicle Loan (Long-Term)	$9,600
Total Non-Current Liabilities	$9,600

TOTAL LIABILITIES	$30,400

EQUITY
Owner’s Capital	$25,000
Retained Earnings	$40,200
Current Year Net Income	$17,400
TOTAL EQUITY	$82,600

TOTAL LIABILITIES + EQUITY	$113,000

Reading This Balance Sheet

Assets: The business has $113,000 in total assets

$45,000 in cash (strong position)
$28,000 owed by customers
$37,000 in equipment and vehicles (net of depreciation)

Liabilities: The business owes $30,400

$20,800 due within the year
$9,600 in long-term vehicle loan
Manageable debt level

Equity: The owner’s stake is $82,600

$25,000 invested
$40,200 in prior year profits retained
$17,400 earned this year

The equation balances: $113,000 = $30,400 + $82,600

Key Balance Sheet Ratios

These ratios help you evaluate financial health:

Current Ratio

Current Assets ÷ Current Liabilities

Can you pay your short-term obligations?

From our example: $76,000 ÷ $20,800 = 3.65

Interpretation:

Above 2.0: Comfortable liquidity
1.5-2.0: Adequate
Below 1.0: Potential trouble paying bills

Quick Ratio (Acid Test)

(Current Assets - Inventory) ÷ Current Liabilities

A stricter test—can you pay obligations without selling inventory?

From our example: ($76,000 - $0) ÷ $20,800 = 3.65 (same, since no inventory)

Target: Above 1.0

Debt-to-Equity Ratio

Total Liabilities ÷ Total Equity

How leveraged is the business?

From our example: $30,400 ÷ $82,600 = 0.37

Interpretation:

Below 1.0: Conservative financing
1.0-2.0: Moderate leverage
Above 2.0: High leverage (riskier)

Working Capital

Current Assets - Current Liabilities

The cushion between what you have and what you owe short-term.

From our example: $76,000 - $20,800 = $55,200

Positive working capital is essential. Negative working capital is a red flag.

What the Balance Sheet Reveals

Financial Stability

Can you weather a downturn?
Do you have reserves?
How much debt are you carrying?

Asset Quality

What do your assets consist of?
Are receivables collectible?
Is equipment up to date or aging?

Financing Decisions

Are you overleveraged?
Do you have capacity to borrow?
Have you retained earnings or distributed everything?

Cash vs. Profit Disconnect

If the P&L shows profit but cash is low, the balance sheet shows where the money went:

Tied up in receivables?
Invested in equipment?
Used to pay down debt?

Common Balance Sheet Problems

Problem: Low Cash Despite Profitability

The P&L shows profit, but cash is chronically low.

Look at:

Accounts Receivable: Are customers paying slowly?
Inventory: Is too much cash tied up in products?
Equipment: Have you made significant purchases?
Owner Draws: Taking more than the business earns?

Problem: High Accounts Receivable

A large receivables balance can signal trouble.

Questions to ask:

Are customers paying on time?
What percentage is overdue?
Are you extending too much credit?
Is any portion uncollectible?

Problem: Negative Equity

When liabilities exceed assets, equity goes negative.

What it means:

The business owes more than it’s worth
Accumulated losses exceed investment and retained earnings
May signal serious trouble

Problem: Growing Debt

If liabilities keep increasing faster than assets:

You’re funding operations with debt
Interest costs will rise
Eventually, borrowing capacity runs out

Connecting Balance Sheet to Business Decisions

Planning Major Purchases

Before buying equipment:

Do you have the cash? (Look at current assets)
Can you afford the payments? (Look at current liabilities)
What’s your current leverage? (Debt-to-equity)

Managing Customer Credit

Review receivables regularly:

Are they growing faster than revenue?
What’s the average collection time?
Who’s slow to pay?

Understanding Cash Position

The cash number on the balance sheet is a starting point:

Minus upcoming payables
Minus upcoming payroll
Plus expected receivables collections

This gives you true available cash.

Evaluating Business Value

If you were to sell:

Assets minus liabilities = book value
This is the floor for business worth
Actual value may be higher (goodwill, customer relationships)

Monthly Balance Sheet Review

Each month, check:

Cash position: Up or down from last month?
Receivables aging: Any getting old?
Payables: Anything overdue?
Debt levels: Increasing or decreasing?
Equity trend: Growing (good) or shrinking (bad)?

Balance Sheet vs. P&L

Aspect	Balance Sheet	P&L
Shows	Position at a point	Activity over time
Time frame	Snapshot	Period (month, year)
Key question	What do we have?	Did we make money?
Assets	Lists them	Doesn’t show
Liabilities	Lists them	Doesn’t show
Revenue/Expenses	Doesn’t show	Lists them
End result	Net worth	Profit/loss

Use together: P&L explains how equity changed. Balance sheet shows the result.

How P&L and Balance Sheet Connect

Net income from the P&L flows to the balance sheet:

You earn $17,400 profit (P&L bottom line)
If kept in business, it increases Retained Earnings (Balance Sheet)
Equity increases by the profit retained
The balance sheet balances with higher assets (cash increased)

If you distribute all profit:

Net income still flows to equity
Owner draws reduce equity by the same amount
Net change to equity is zero

Your Balance Sheet Action Items

This Month

Pull your current balance sheet
Calculate current ratio and debt-to-equity
Review your receivables aging

Quarterly

Compare balance sheet to prior quarter
Track equity trend
Review all asset and liability categories

Annually

Clean up old items
Verify asset values
Consider write-offs for uncollectible receivables
Discuss with accountant before tax filing

Next Steps

To get comfortable with your balance sheet:

Pull your balance sheet from your accounting software
Calculate the key ratios discussed above
Compare to last month and last year
Identify one thing that concerns you and investigate
Ask your bookkeeper or accountant about anything you don’t understand

The balance sheet isn’t just for banks and investors. It’s a powerful tool for understanding your business’s true financial position.

Need help understanding your financial statements? At Profit Path Books, we help small business owners understand their numbers—not just produce reports. Book a consultation to discuss your business finances.