What is the purpose of a balance sheet: Definition and role in business management

The balance sheet is a fundamental financial statement for any business, whether it is growing or structuring its financial foundation. It provides a clear view of a company’s financial position at a specific point in time, detailing total assets, total liabilities, and shareholders' equity.

Beyond being an essential document for financial management, the balance sheet is a legal requirement for businesses in Canada, particularly for corporate tax filings, such as the T2 and CO-17 tax returns. It also plays a key role in financial decision-making, whether for business loans, investments, or assessing the financial health of a company.

In this article, we will explain what a balance sheet is, how it works, and how to read, create, and optimize it to ensure financial stability and tax compliance.

What is a Balance Sheet? Definition & balance sheet equation

A balance sheet is a financial statement that reports a company’s financial position at a specific point in time. It is usually prepared at the close of the financial year for the preparation of the corporate tax return, but may also be prepared in connection with a loan application, a tax audit or a financial valuation.

The balance sheet follows a fundamental equation:

👉 Assets = Liabilities + Shareholders' Equity

 

The three key components of a balance sheet

1. Assets: What the company owns

Assets include everything that a business owns or controls and that can be converted into cash. They are divided into:

• Fixed assets: Long-term resources, such as real estate, machinery, vehicles, and intangible assets (e.g., patents, trademarks).
• Current assets: Short-term resources such as cash, accounts receivable, inventory, and prepaid expenses.

2. Liabilities: What the company owes

Liabilities represent the company’s financial obligations, including:

• Long-term liabilities: Debts payable over a longer period, such as mortgages, bonds, and deferred tax liabilities.
• Current liabilities: Short-term debts such as accounts payable, salaries payable, and short-term loans.

3. Shareholders' equity: What belongs to the owners

Equity represents the financial foundation of the business and includes:

• Share capital: Investments made by shareholders.
• Retained earnings: Profits reinvested in the business instead of being distributed as dividends.
• Reserves: Working capital and undistributed dividends.

What does a balance sheet show? How to read a balance sheet

A balance sheet is more than just a financial requirement. It is an essential financial statement that provides a snapshot of a company's financial health at a specific point in time. This document is crucial for financial management, investment decisions, and corporate tax compliance.

📊 A clear overview of financial health

A well-structured balance sheet allows business owners to better understand the financial health of their company. It helps to:

• Monitor cash flow availability and anticipate future financial needs.
• Evaluate investment capacity based on total assets and total liabilities.
• Identify financial imbalances, such as excessive debt or liquidity shortages.

Example: If a company’s current assets total $50,000, but its current liabilities amount to $80,000, it may face cash flow issues and struggle to meet its short-term obligations.

📈 A key tool for banks and investors

Lenders, investors, and business partners rely on the balance sheet to assess the company's financial position before making business decisions. It helps them:

• Evaluate creditworthiness before approving a business loan.
• Measure profitability and financial stability through key financial ratios.
• Determine credit terms and conditions for supplier payment agreements.

Example: If an investor is considering a $100,000 investment, they will analyze the company’s balance sheet to check its equity, debt levels, and liquidity ratios before deciding.

📝 A requirement for corporate tax filings

The balance sheet is essential for corporate tax filings, particularly for T2 corporate income tax returns (federal) and CO-17 tax returns (Quebec). The Canada Revenue Agency (CRA) and Revenu Québec require a detailed balance sheet to:

• Determine corporate tax liability based on net income.
• Reconcile reported income with the company's other financial statements.
• Assess eligibility for investment tax credits and deductions.

Risks of an inaccurate balance sheet:

• Tax audits and financial reviews by authorities.
• Potential financial penalties for discrepancies or accounting errors.
• Delays in tax return processing, affecting the company’s cash flow.

Example: If a company fails to include a bank loan in its balance sheet, it may distort its financial expenses and lead to an underestimation of deductible expenses, thus increasing the tax payable.

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📊 The balance sheet and other financial statements: a holistic view

A balance sheet is one of the core financial statements used to analyze a business, but it should not be examined in isolation. It is closely connected to other reports:

The income statement:

• The income statement shows income and expenses to determine net income.
• Some balance sheet accounts, such as depreciation on fixed assets, are reflected in the income statement.

The cash flow statement:

• The cash flow statement explains the inflows and outflows of cash from operations.
• Some balance sheet elements, like loans, accounts receivable, and payables, directly affect cash flow.

Example: f a company purchases a truck for $100,000, it will be recorded as a fixed asset on the balance sheet, while the loan used for the purchase will appear as a liability. The depreciation expense will then be recorded in the income statement, and the cash impact will be detailed in the cash flow statement.

📏 Key financial ratios derived from the balance sheet

A balance sheet allows businesses to calculate key financial ratios to assess liquidity, debt management, and profitability, including:

Liquidity ratio: Measures whether the company has enough current assets to cover current liabilities.

👉 Current assets ÷ Current liabilities

Leverage ratio: Determines how much the company relies on debt financing compared to shareholder equity.

👉 Total liabilities ÷ Equity

Debt-to-equity ratio: Indicates whether the company’s operations are funded through borrowed money or retained earnings.

👉 Debt ÷ Equity

Example: A company with a liquidity ratio of 1.5 has $1.50 in liquid assets for every $1.00 of liabilities, signaling strong financial health.

How to make a balance sheet​ and avoid common mistakes

Creating a balance sheet requires accuracy, compliance with accounting standards, and proper classification of assets and liabilities. A well-prepared balance sheet is essential for tax compliance, financial decision-making, and investment planning.

Follow these three key steps to create a balance sheet, ensuring its accuracy while avoiding common financial reporting errors that could distort your company’s financial health.

1. Drawing up an inventory of assets and liabilities

The balance sheet is a financial statement that presents a snapshot of a company’s financial position at a specific point in time. To ensure accuracy, business owners must list all assets and liabilities while considering their true financial value.

✅ To do:

• List all assets, including fixed assets (real estate, equipment, vehicles) and current assets (inventory, accounts receivable, cash balance).
   
• Check the value of assets, based on depreciation schedules, market value, and net realizable value.
• List all debts and liabilities, including long-term liabilities (bank loans) and current liabilities (accounts payable, taxes payable, and accounting provisions).

❌ Mistakes to avoid:

• Overestimating or underestimating total assets: Incorrect valuation can distort financial position and mislead investors or lenders.
• Forgetting liabilities: Missing a debt (e.g., a newly contracted loan) misrepresents debt-to-equity ratio, leading to financial miscalculations.

2. Check the accuracy of accounting entries

Accurate accounting records ensure that transactions are correctly reflected in the balance sheet and other financial statements. A balance sheet must align with the income statement and cash flow statement to provide a reliable financial overview.

✅ To do:

• Perform bank reconciliation: Ensure that all recorded transactions match bank statements and cash account balances.
• Check consistency with income statement: Sales, expenses, and depreciation expenses must align with revenues and costs.
• Review accounts receivable and accounts payable: Confirm that outstanding invoices and unpaid debts are correctly reflected.

 ❌ Mistakes to avoid:

• Forgetting transactions: Unrecorded invoices or pending payments skew financial analysis and tax calculations.
• Confusing income received with income receivable: Accrual accounting requires that revenues be recorded when earned, not when payment is received.
• Incorrectly recording provisions: Future expenses (e.g., taxes payable, employee benefits) must be anticipated and recorded in the correct period.

3. Comply with accounting standards and correctly categorize items

Proper financial reporting requires businesses to follow Canadian accounting principles, ensuring compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

✅ To do:

• Use accrual accounting: Recognize revenues and expenses when they occur, not when payment is received.
• Apply depreciation rules: Fixed assets must be depreciated over their useful life to reflect true financial value.
• Differentiate between expenses and investments: Expenses that provide long-term benefits should be recorded as fixed assets, not operating expenses.

 ❌ Mistakes to avoid:

• Misclassify expenses: Misreporting short-term expenses as capital investments can distort profitability analysis.
• Neglecting depreciation of fixed assets: Failing to account for asset depreciation can inflate total assets, creating a misleading financial position.
• Not checking tax obligations: Some companies forget to include sales tax (GST/QST) in their receivables or payables, leading to compliance issues.

Balance Sheet example

FAQ: Frequently Asked Questions

What is the difference between a balance sheet and a profit and loss statement?

The balance sheet is a financial statement that provides a snapshot of a company’s financial position at a specific point in time. It shows total assets, liabilities, and shareholders’ equity, allowing business owners and stakeholders to assess financial health and solvency.

The income statement, on the other hand, measures a company’s financial performance over a period (monthly, quarterly, or annually). It summarizes revenues, expenses, and net income, helping businesses understand their profitability.

How often should a balance sheet be prepared?

Balance sheets are generally prepared annually at the end of the fiscal year, especially for corporate tax filings. However, some businesses opt for quarterly or monthly balance sheets to closely track their cash flow, accounts receivable, and financial health.

Regular updates to the balance sheet allow companies to identify liquidity issues and adjust their financial strategy accordingly. Banks and lenders often require an updated balance sheet when evaluating a loan request.

What documents do I need to prepare a balance sheet?

In order to prepare an accurate balance sheet, it's essential to collect all the financial documents that show the company's situation. These documents include invoices issued and received, bank statements, a complete list of debts and liabilities, and information on inventories and fixed assets. A depreciation schedule and a trial balance are also essential to ensure the consistency and accuracy of accounting entries.

Can I do my own balance sheet or do I need an accountant?

It's possible to do your own balance sheet using accounting software, especially for a small business with few transactions. However, an accountant ensures tax compliance, avoids errors and optimizes financial management, especially for growing businesses or those with complex tax obligations.

Does the balance sheet show net income?

The balance sheet does not directly show net income, which is mainly reported in the income statement. However, net income affects the balance sheet through equity, particularly retained earnings, which represent net income after taxes and dividends.

Simplify your accounting with the experts at T2inc.ca

Drawing up an accurate balance sheet is essential to optimize your financial management and tax obligations. A mistake can cost you dearly in taxes and complicate your relations with banks and investors.
At T2inc.ca, we support you in preparing your T2 tax returns and your Quebec CO-17 tax returns. We have a team of accountants and partners to help you finalize your financial statements, including your balance sheet, if these are not done. Entrust your accounting to our corporate tax experts and ensure fast, reliable service that complies with Canadian requirements.

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