How to Read a Balance Sheet: The Owner's Five-Line Check
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Your P&L says the business has earned $417,000 so far this year. The balance sheet says where that money is now: in the bank, in clients' hands, in paid-down debt, or in your pocket. To read a balance sheet, check it in a fixed order: clearing accounts first (is it trustworthy?), then cash, receivables, short-term obligations, and equity. That's five lines and about ten minutes a month.
Every balance sheet follows one equation:
Assets = Liabilities + Equity
Assets are what the business owns or is owed. Liabilities are what it owes. Equity is what's left for the owners. If it doesn't balance, it isn't a balance sheet. But a sheet that balances can still be wrong, which is why the first line in this check isn't cash.
The hypothetical balance sheet we'll read
This example is hypothetical: a $4M-revenue consulting firm, accrual basis, at month-end.
| Line | Amount |
|---|---|
| Assets | |
| Operating cash | $185,000 |
| Accounts receivable | $610,000 |
| Undeposited funds | $42,000 |
| Prepaid expenses | $18,000 |
| Equipment, net | $35,000 |
| Total assets | $890,000 |
| Liabilities | |
| Accounts payable | $95,000 |
| Credit cards | $38,000 |
| Accrued payroll and payroll taxes | $120,000 |
| Customer deposits | $60,000 |
| Line of credit | $150,000 |
| Loan from shareholder | $80,000 |
| Total liabilities | $543,000 |
| Equity | |
| Retained earnings (prior years) | $210,000 |
| Distributions (year to date) | ($280,000) |
| Net income (year to date) | $417,000 |
| Total equity | $347,000 |
| Total liabilities and equity | $890,000 |
Now the five lines.
Line 1: Clearing accounts should be zero
Look for anything named undeposited funds, suspense, "ask my accountant," uncategorized, or clearing. These are holding pens. At month-end they should be zero or close to it.
Our hypothetical firm has $42,000 in undeposited funds. That's either cash recorded as received but never matched to a deposit, or deposits recorded twice. Either way, both cash and receivables are unreliable until someone fixes it.
Bennett rule: if any clearing account carries a balance at month-end, stop reading and send it back. Every ratio after this depends on the numbers being real.
Line 2: Cash against what's due in the next 30 days
Cash on the balance sheet is a single date. It tells you nothing until you compare it with what has to go out.
Here, $185,000 of cash sits against $120,000 of accrued payroll and payroll taxes and $38,000 of credit cards, both due within weeks, plus $95,000 of payables. That's $253,000 of near-term obligations against $185,000 of cash. The gap gets filled by collections, which is why line 3 matters.
For how much cash a service firm should hold as a standing reserve, Bennett's cash reserve formula works from monthly fixed costs. The balance sheet tells you whether you're above it today.
Line 3: Receivables, measured in days
Receivables are the biggest asset on most service-business balance sheets, and the most likely to be overstated. Convert the dollar figure into days:
DSO = Accounts receivable ÷ Annual revenue × 365
For the firm: $610,000 ÷ $4,000,000 × 365 = about 56 days.
Fifty-six days on net-30 terms means a meaningful share of clients are paying late. Ask for the AR aging. If more than a small slice sits beyond 90 days, ask which of it is truly collectible. A balance sheet full of uncollectible receivables shows profit you'll never bank.
Line 4: Short-term obligations, including the ones that don't look like debt
Most owners look at the line of credit and stop. Read every current liability, because several don't feel like debt:
- Customer deposits ($60,000) are cash you've collected for work you haven't done. You owe the work, or a refund. Spending deposits to fund operations is a common way firms end up short. Bennett's piece on customer deposit accounting goes deeper.
- Accrued payroll and payroll taxes ($120,000) are owed to employees and taxing authorities on fixed dates.
- Loan from shareholder ($80,000) is money you put in. It can be repaid, but a lender will often want it subordinated.
Then run the quick test:
Current ratio = Current assets ÷ Current liabilities
Current assets here are $855,000 (cash, AR, undeposited funds, prepaids). Current liabilities are $463,000 if the line of credit is current and the shareholder loan isn't. That's a ratio of about 1.8. On paper, fine. Strip out the $42,000 in undeposited funds and, say, $60,000 of AR over 90 days (a hypothetical figure for this firm), and current assets drop to $753,000. That's a ratio of about 1.6, still above 1 but with noticeably less room than the headline suggests. The seven ratios article puts this ratio in context with the others Bennett reads.
A balance sheet that balances can still hide a cash problem in receivables, deposits, or payroll accruals. If you can read off your cash, AR, and deposit balances, a Leak Check built around your working capital can point to which of those lines is holding your profit, without you sending the statement.
Line 5: Equity, and what it says about how you've paid yourself
Equity is the scoreboard of everything the business has earned and kept. Read three pieces:
- Retained earnings from prior years: $210,000.
- Distributions this year: $280,000.
- Net income this year: $417,000.
The firm has earned $417,000 and distributed $280,000, so it's keeping about a third of this year's profit. That's a conscious choice worth making explicitly. If distributions run ahead of net income for long, equity shrinks, and eventually goes negative. A lender will notice that before you do.
Equity is also where cash-basis and accrual-basis books diverge most. If your books are on a cash basis, receivables and payables aren't on the balance sheet at all, and equity reflects cash collected rather than revenue earned. Bennett's comparison of cash vs. accrual accounting covers when the switch is worth it.
Read two months side by side
One balance sheet is a photo. Two are a story. Put this month next to last month and look at the change in each of the five lines:
| Line | Last month | This month | Change | What it suggests |
|---|---|---|---|---|
| Cash | $240,000 | $185,000 | ($55,000) | Cash fell even though the month was profitable |
| Accounts receivable | $540,000 | $610,000 | +$70,000 | Billing outran collections |
| Customer deposits | $85,000 | $60,000 | ($25,000) | Work delivered against deposits, no new deposits |
| Distributions YTD | $240,000 | $280,000 | +$40,000 | Owner took $40,000 this month |
The story: a month with $80,000 of net income, but $70,000 more is now sitting in receivables, $25,000 of prepaid work was delivered, and $40,000 went to the owner. Profit of $80,000 minus those three uses of $135,000 explains the $55,000 drop in cash (ignoring smaller movements), and you got there without a single P&L line. This is exactly the question the monthly bookkeeping reports should answer together.
Why the IRS cares about this statement too
S corporations report a balance sheet on Schedule L of Form 1120-S, and the IRS instructions say those balance sheets should agree with the corporation's books and records. The only exemption is when the corporation answers yes to Schedule B question 11, which requires both total receipts and total assets below $250,000. A $1M-plus service business won't qualify. So the balance sheet your CPA files has to tie to your books, and messy clearing accounts become a tax-return problem, not just a management one.
What good looks like
A balance sheet is ready for decisions when clearing accounts are at zero, receivables are aged and mostly current, every liability has a due date someone can name, and equity reconciles to what you've earned and taken. When it isn't, the gap usually traces to the close process, not the bookkeeper's effort.
If reading these five lines raises more questions than it answers, that's the work a fractional CFO does every month: turning the balance sheet into a cash decision.
This month, open your balance sheet and do one calculation: DSO from line 3. If it's more than 15 days past your payment terms, that's the number to chase first. And if clearing accounts aren't zero, fix that before you trust anything else, then use a Leak Check to see what the corrected statement says about cash.
Frequently asked questions
What is the difference between a balance sheet and a P&L?
The P&L measures earnings over a period. The balance sheet shows what the business owns, owes, and has left for owners on a single date. Profit can rise while cash falls because the balance sheet absorbs it in receivables, debt payments, or distributions.
Should a balance sheet be prepared on cash or accrual basis?
Accrual gives the more useful picture for a service business because it shows receivables, payables, and accrued payroll. A cash-basis balance sheet omits those, so it can look healthier or weaker than reality.
Why does my balance sheet show money in undeposited funds?
Payments were recorded as received but not matched to a bank deposit, or a deposit was recorded separately and the payment never cleared the holding account. Either way, the bookkeeper should clear it before month-end.
Is a shareholder loan a liability or equity?
If it's documented as a loan with repayment terms, it's normally a liability. Lenders may treat it like equity if it's subordinated to their debt, so the documentation matters.
What current ratio should a service business have?
Many lenders look for current assets comfortably above current liabilities. More useful than a single target is recalculating the ratio after removing aged receivables and clearing-account balances to see the cash-backed figure.
How often should an owner review the balance sheet?
Monthly, after the close, compared with the prior month. A quarterly look is too infrequent to catch receivables or deposit swings before they become a cash problem.
Does the IRS require a balance sheet on an S corporation return?
Yes, on Form 1120-S Schedule L, unless the corporation answers yes to Schedule B question 11, which requires total receipts and total assets both under $250,000. The instructions say the balance sheets should agree with the books.
Why is equity on my balance sheet lower than my profit this year?
Distributions reduce equity, and prior-year retained earnings may be small or negative. If you distributed most of this year's profit, equity grows only by what you kept.