What Is a Balance Sheet?

A balance sheet is a financial statement that provides a snapshot of a business’s financial position at a specific point in time. It summarises what the business owns (assets), owes (liabilities), and the owner’s equity. Think of it as a scorecard that tells you how well your business is performing financially.

Why is it important?

For businesses, a balance sheet is not just an internal tool but also a critical document for external stakeholders, especially lenders. It helps:

• Evaluate financial health: Provides a clear picture of liquidity, solvency, and profitability.
• Facilitate decision-making: Assists in planning investments, managing debts, and allocating resources effectively.
• Gain lender confidence: Lenders use the balance sheet to determine your ability to repay loans and manage financial risks.

When you apply for a business loan, lenders scrutinise your balance sheet to assess your financial stability. This document is crucial because it offers insights into your company’s financial structure and ability to meet debt obligations.

How lenders evaluate balance sheets

Lenders use balance sheets to:

1. Assess solvency: They check if your assets outweigh your liabilities. A positive net worth indicates financial stability.
2. Analyse liquidity: Liquidity ratios help lenders understand if you can meet short-term obligations.
3. Evaluate debt levels: High debt-to-equity ratios may signal financial risk, whereas balanced ratios indicate prudent financial management.

Real-world implications

For example, if your balance sheet shows a strong current ratio (assets greater than liabilities), lenders are more likely to approve your loan application. Conversely, inconsistencies or inaccuracies in your balance sheet can lead to rejection.

A balance sheet is divided into three main sections:

Interrelationship of components

The balance sheet follows the equation:
Assets = Liabilities + Equity
For instance, if your business owns Rs. 50 lakh in assets and owes Rs. 20 lakh in liabilities, the equity would be Rs. 30 lakh. This equation must always balance, ensuring the accuracy of your financial statements.

Lenders follow a systematic process to evaluate your balance sheet. Here is a step-by-step breakdown:

1. Reviewing assets:
   • Lenders prioritise liquid assets like cash and accounts receivable.
   • They assess whether your assets can cover short-term liabilities.
2. Examining liabilities:
   • They look at the type of liabilities (short-term vs long-term) and their repayment schedules.
   • Excessive short-term liabilities may raise concerns about liquidity.
3. Evaluating equity:
   • A strong equity base indicates financial stability.
   • Negative equity may signal financial distress.
4. Calculating financial ratios:
   • Ratios like the current ratio and debt-to-equity ratio help measure financial health.
   • These ratios are critical for determining loan eligibility.

Tips for improving balance sheet readability

• Use clear, consistent formatting.
• Ensure all figures are accurate and up-to-date.
• Highlight key metrics that demonstrate financial stability.

Lenders rely on specific financial ratios derived from balance sheets to evaluate loan applications. Here are the most critical ones:

1. Current ratio:
   • Formula: Current Assets ÷ Current Liabilities
   • Indicates short-term financial health. A ratio above 1 is generally favourable.
2. Debt-to-equity ratio:
   • Formula: Total Liabilities ÷ Shareholder’s Equity
   • Measures financial leverage. Lower ratios indicate less reliance on debt.
3. Net worth ratio:
   • Formula: Equity ÷ Total Assets
   • Reflects the owner’s stake in the business.
4. Quick ratio:
   • Formula: (Current Assets - Inventory) ÷ Current Liabilities
   • A stricter measure of liquidity compared to the current ratio.

The current ratio is a key indicator of a business’s ability to meet short-term obligations. For example, if your current assets are Rs. 10 lakh and current liabilities are Rs. 5 lakh, your current ratio is 2. This suggests that your business has twice the assets needed to cover liabilities, which is favourable for loan approval.

This ratio highlights the balance between debt and equity financing. For instance, if your liabilities are Rs. 40 lakh and equity is Rs. 20 lakh, your debt-to-equity ratio is 2. While lenders prefer lower ratios, the acceptable range varies by industry.

Follow these steps to create an accurate balance sheet:

1. List all assets: Categorise them into current (cash, inventory) and non-current (property, equipment).
2. List all liabilities: Include both short-term (payables) and long-term (loans).
3. Calculate equity: Subtract liabilities from assets to determine equity.
4. Ensure accuracy: Double-check figures and ensure they align with your trial balance.
5. Format professionally: Use clear headings and consistent formatting.

Common errors to avoid

• Misclassifying assets and liabilities.
• Ignoring depreciation for fixed assets.
• Failing to reconcile balances with supporting documents.

Avoid these pitfalls to improve your chances of loan approval:

• Data inconsistencies: Discrepancies between the balance sheet and other financial statements.
• Overstated assets: Inflating asset values can lead to credibility issues.
• Undisclosed liabilities: Hiding debts may result in immediate rejection.

Solutions

• Regularly audit your financial statements.
• Use accounting software to minimise errors.
• Seek professional help for complex financial reporting.

While both are essential, lenders focus on balance sheets for loan approvals as they provide a clearer picture of financial stability.

A trial balance is a preliminary report that lists all ledger account balances. It serves as the foundation for preparing the balance sheet. For instance, if your trial balance shows Rs. 10 lakh in total assets and Rs. 6 lakh in liabilities, the balance sheet will reflect these figures, ensuring the equation balances.

Projected balance sheets estimate future financial positions, which are vital for business plans and loan applications.

Steps to create one:

1. Forecast revenue and expenses: Base projections on historical data and market trends.
2. Estimate asset growth: Account for planned investments.
3. Predict liabilities: Include expected loans and other obligations.
4. Calculate equity: Adjust based on projected profits or losses.

For example, if you plan to purchase machinery worth Rs. 5 lakh next year, include this under non-current assets in the projected balance sheet.

Conclusion

A well-prepared balance sheet is more than just a financial statement; it is a gateway to securing business loans and demonstrating financial stability. By understanding its components, key ratios, and common mistakes, you can enhance your loan eligibility and build lender confidence.

At Bajaj Finserv, we offer tailored business loan solutions to help you achieve your financial goals. With flexible terms and competitive rates, we make financing simpler and more accessible. Apply for a business loan today and take the next step towards growing your business.