Taking Some of the Mystery Out of the Balance Sheet
Understanding the different types of financial statements that can be prepared for your business, and being fluent with the information each contains helps you better understand your financial position and make more informed decisions about your business. Remember – forewarned is forearmed…and you can’t manage until you measure! That being said, I have found that a critical measuring tool – the Balance Sheet – is often overlooked by small business owners – likely because they don’t understand its importance. Let’s see if we can change that…
The Balance Sheet is merely a snapshot of your company’s financial position as of a given point in time. Today’s balance sheet could be different tomorrow – simply by writing out a check, or invoicing a client. This financial statement provides the details your assets, liabilities and equity – the three components of a business’ financial accounting – as of a particular date. Although balance sheets may be created as of any date, they are typically prepared at the end of an accounting period, such as a month, quarter or year.
The Balance Sheet is layed out in a particular fashion that reflects one of the most basic precepts of accounting:
Assets = Liabilities + Owners’ Equity or A=L+C
Since we are dealing with an equation, one side must ultimately and always equal the other side (think back to high school algebra!) Therefore, the total dollar amount is always the same for each side, i.e., total assets will always equal the total of liabilities + capital (or equity). Stated differently, the left and right sides of a balance sheet are always in balance. Some balance sheets will have assets at the top and liabilities and capital at the bottom…no matter…A will always = L + C.
Assets are the things your business owns that have some monetary value. Your assets are tangible items such as cash, inventory, buildings, land, and equipment, as well as investments, prepaid expenses and money owed to you (accounts receivable, notes receivable, etc.)
On a balance sheet, assets are listed in groups based on their liquidity. Liquidity is a measure of how quickly these assets can be converted into cash, sold or consumed. Current assets – assets that one can reasonably expect to be converted into cash within a year (e.g., accounts receivable) or can be converted into cash on demand (e.g., stocks) are listed first on the left-hand side and then totaled. Fixed assets follow next – fixed assets are expected to be around a while and persist – these include buildings, vehicles and equipment.
Finally, total assets are added-up at the bottom of the assets section of the balance sheet.
Liabilities reflect all the money your business owes out to others. This includes amounts owed on loans, accounts payable, wages, taxes and other debts. Similar to assets, liabilities are categorized based on their due date, or the timeframe within which you expect to pay them. Current liabilities are expected to be paid within a year; long-term liabilities in more than a year.
Current liabilities are generally due within a year of the balance sheet date and are listed at the top of the right-hand column and then totaled, followed by a list of long-term liabilities, those obligations that will not become due for more than a year.
Owners’ equity (sometimes called net assets or net worth or capital) represents the assets that remain after deducting what you owe. In simplified terms, it is the money you would have left over if you sold your business and all of its assets and paid off everything you owe.
Depending upon the structure of your business, owners’ equity may be your own (sole proprietorship), collective ownership rights (partnership), or stockholder ownership plus the earnings retained by the company to grow the business (corporation).
Total liabilities and owners’ equity are totaled at the bottom of the right side of the balance sheet.
With balance sheet data, you can evaluate important indicators concerning your business – such as your ability to meet financial obligations (current ratio, days cash on hand) and how effectively you use credit to finance your operations (debt ratio, debt to equity ratio).
Although the balance sheet represents a given moment suspended in time, it can be prepared to include information from the previous accounting period for comparative purposes. This will permit you to evaluate how your business is performing over time.
Compare the current reporting period with previous ones using a percent change analysis. Do you have more assets? Have you accrued more debt? Invested in equipment and facilities? Are your pressing financial obligations (current liabilities) under control? Is the amount that payers owe you growing? Calculating financial ratios and trends can help you identify potential financial problems that may not be obvious.
Often overlooked by the small business owner, the balance sheet can be a critical decision making tool…it is like taking the pulse of your business. Fear it no longer!
