What is the purpose of a balance sheet?

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Key Takeaways

A startup's balance sheet is an official report of its liabilities, assets, and shareholder equity at a given moment. As a financial statement, a balance sheet serves as a foundation for investors to calculate RoR (Rate of Return) and for assessing the combination of equity and debt that comprises your startup's finances.
Just because a balance sheet does not comprise revenue does not imply that it does not hold as much value or importance for investors as other types of financial statements do. In fact, investors trust the balance sheet to spell out the financing/support behind a startup's assets; this, in turn, offers an insight into your startup's financial well-being.
There are several benefits of a balance sheet. It offers several key insights (especially those related to risk and return), helps with raising capital (especially taking out loans), and can be used to compute certain important financial ratios.
At the same time, the balance sheet is not without its limitations. It records historical costs that might not be the same as the current market valuation of assets, comprises assets whose values are estimated (such as intangibles like goodwill), doesn’t reflect assets that are not strictly monetary, and only works for its own time period.

What is a balance sheet?

Your startup's balance sheet is an official report of its liabilities, assets, and shareholder equity at a given moment. As a financial statement, a balance sheet serves as a foundation for investors to calculate RoR (Rate of Return) and for assessing the combination of equity and debt that comprises your startup's finances.

Thus, a balance sheet depicts a summary/record of:

Everything that’s owned by the startup
Everything that’s owed by the startup
The investment made by shareholders

It is used along with the rest of your startup's key financial statements for carrying out fundamental analysis. All in all, a balance sheet presents an organization-wide summary of your startup's finances at a specific point in time.

A balance sheet can also be used to help compute financial ratios like debt-to-equity ratio, acid-test ratio, etc. Why are these ratios important? Because they give investors an insight into the financial health of your startup. In fact, there are often references to the balance sheet in earnings reports; these references, along with the accompanying notes/details, certainly help in evaluating the financial well-being of your startup.

The accounting formula for the balance sheet is:

Liabilities + Shareholders’ Equity = Assets

Both sides balance out. Most founders understand this equation as the basic principle is simple: all assets held by the startup are paid for by either debt (i.e., liabilities) or raising capital (i.e., getting funds from investors in exchange for giving out shareholder equity).

For example, consider a startup that goes to a bank and borrows $5000 as a four-year loan. When it does so, its assets (the cash book, to be precise) go up by $5000. Similarly, its liabilities (the long-term debt book in particular) go up by $5000. This creates a balance between both sides of the formula.

Similarly, if your startup gets $10,000 from its investors, its assets will go up by $10,000 -- and so will its shareholder equity. Now, let’s say that your startup earns revenue that is more than its expenses. When this happens, then the surplus revenue will be used for the shareholder equity account. This will be shown in the form of assets (e.g., cash, inventory, etc.). Thus, the surplus revenue will be balanced on the assets side.

An important point to remember is that the attitudes toward financing differ between various industries. Therefore, your startup's balance sheet would be contrasted against the balance sheets of companies operating in the same industry.

What is the purpose of a balance sheet?

It’s crucial that the accounting equation (that’s explained above) for the balance sheet be balanced on both sides. This is because as the assets of a startup increase, there must be an equivalent increase in its shareholders’ equity and/or liabilities for there to be a healthy balance in the startup's financial status.

Just because a balance sheet does not reflect revenue does not imply that it isn't as important to investors as other types of financial statements. In fact, investors trust the balance sheet to reflect a startup's financial well-being.

For example, if the value of equity is more than that of liabilities, then investors see that as an indicator of a good investment. On the other hand, if liabilities are excessive, then it could be a sign to investors that financial difficulties are on the horizon for the startup.

A great balance sheet template can be found here.

Here’s a balance sheet example from Amazon in 2017:

Benefits of a balance sheet

Financial reporting is something that founders should treat as being extremely important. As a founder, it’s crucial to put together -- and have a good understanding of -- your startup’s financial statements. The balance sheet can be trusted to update founders as well as other stakeholders on the startup's financial position. If all this data is up to date, then more effective decisions can be taken related to managing the startup and streamlining its operations and borrowing practices.

Following are the benefits of a balance sheet:

Identifying Risk and Return

Looking for a single source that clearly summarizes the startup's assets and liabilities? The balance sheet is your go-to financial statement.

Several key insights -- especially those relevant to risk and return -- can be derived from the balance sheet. For example, the list of the startup's assets (both current and fixed/capital assets) show a lot about its capacity to produce cash and keep operations going at an optimal pace. On the other hand, debts (both short and long-term) are a reflection of the startup's financial responsibilities.

Therefore, a general rule of thumb is to aim for more assets than liabilities. When this occurs, it is a sign of positive net worth.

A balance sheet helps in determining if a startup can fulfill its short-term financial responsibilities. This can be done by contrasting current assets with current liabilities. When the former is less than the latter, then the startup will probably need to borrow extra working capital.

The balance sheet can tell founders when their startup's outstanding debt has become excessive and reached a level where it can’t be maintained. A startup with excessive debt could very well end up with a debt default -- or, worse, be forced to declare bankruptcy. Thus, the balance sheet can also point out problems that can turn into critical financial issues in the future.

Helps with raising capital -- especially loans

The balance sheet is instrumental to a startup in securing loans and other types of capital. It's an opportunity for those who are not inside the business to quickly understand the state of its financial affairs.

In fact, your startup's balance sheet will be required by a majority of lenders, such as banks, to answer questions like:

How robust has the financial well-being of your startup been in the past and in general?
Is the credit history of the founder(s) good?
Has the startup maintained a good track record of debt repayment?

Prospective investors could ask to see the balance sheet to see where their money will go. They will also be able to anticipate what the repayment timeline might look like.

Up-to-date balance sheets demonstrate your startup's capacity to collect payments from customers/clients and repay its debts. It also illustrates your startup's history of handling assets and liabilities in a responsible manner. This is of particular interest to lenders when you approach them for a loan. It proves to them that you would be able to repay a potential loan in a timely manner.

Financial ratios

There are certain financial ratios that are derived from the balance sheet.

When assessing how a startup is doing in terms of like solvency, profitability, liquid assets, and productivity, these ratios become extremely useful. Ratios are also used to analyze what the sustainability of a startup would look like over the long term.

The capital structure of the startup is disclosed in the balance sheet; it shows how debt and equity are distributed. The balance sheet also shows the time that it takes for the startup to sell its entire stock and collect its accounts receivable.

This knowledge helps founders recognize trends and patterns and to contrast the operational and financial aspects of their startup with similar players in the market.

Limitations of a balance sheet

Though balance sheets are extremely important, they have their limitations. The following are the three limitations of a balance sheet:

Historical costs

The value of assets included in the balance sheet is not always true. This is because the assets are recorded at what their original cost was when they were acquired by the startup. This is known as historical cost, a measure that is considered incorrect because it may not reflect the recent market value of the asset. As it does not account for the potential impact of depreciation on the asset’s price, the balance sheet does not include the asset’s carrying value. The historical cost that is recorded on the balance sheet will only be equal to the asset’s current market value if the asset’s original price did not undergo any changes since its purchase.

Estimated values

There may be some current assets on the balance sheet with an estimated value, meaning the actual financial condition of the startup is not accurately reflected. For example, intangible assets are assigned imaginary values that don’t really go along with the market valuation. This could include an intangible like goodwill. The International Accounting Standards Board has developed some guidelines on how values should be assigned to intangibles in financial statements.

Does not reflect assets that are not strictly monetary

Another limitation of the balance sheet is that it does not reflect non-monetary assets that are valuable in their own right. These are assets that can’t be recorded in monetary terms. Some examples are integrity, proficiency, skill, and trustworthiness of employees.

Only works for its own time period

Founders can’t get a reliable grasp of trends developing over a longer period of time through the balance sheet alone. Therefore, they should not contrast a balance sheet with older balance sheets.

How to calculate common stock on the balance sheet

Common stock is a kind of security that grants a level of ownership of a startup to the holder of the security. The person holding it also gets voting rights.

Here’s the formula to calculate common stock on the balance sheet:

Source

The reason that the second formula is given in the image above is that it works for the majority of startups that issue a single class of stock -- as opposed to having a dual-class stock structure. This is because these startups often have zero amounts of treasury stock, additional paid-in capital, and preferred stock. In such cases, only the retained earnings need to be deducted from the total equity.

Example

Let’s say that as per a startup’s balance sheet on November 1, 2021, the startup has $60,000 worth of total equity that belongs to its owners or stockholders. Its retained earnings are $30,000 as of the reporting date.

Then,

Common stock = total equity - retained earnings

Or,

Common stock = $60,000 - $30,000 = $30,000

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