“What the…?” Part 3: What is a Balance Sheet???
September 17, 2015
Ah, the balance sheet. So overlooked, so misunderstood, so integral to your business. You are not alone if you can honestly admit you have NO CLUE how to read this report or have the foggiest idea what it means. Let’s break it down, shall we?
The Balance Sheet is like a snapshot of your business, showing its health. Rather than covering a period of time, a balance sheet report is for a certain date, usually at the end of a period (like the 31st of a month, end of a quarter, or 12/31 of the year).
The Accounting Equation. Some of you may have heard of the accounting equation in Business 101 or possibly in a small business class. What is the accounting equation? It is the formula for the Balance Sheet:
Assets = Liabilities + Owner’s Equity
Let’s break it down further. Assets consititute stuff that is yours or money owed to you. Cash from banking/savings accounts, your accounts receivable (money owed to you by customers), any loans you’ve provided to other people, inventory, furniture, fixtures, equipment, buildings and land that you own. These are all things that belong to YOU and cause you to slide toward positive on the net worth scale. Typically, assets are listed in order of liquidity (how quickly you can convert them to cash), starting with cash, ending with buildings and land.
Conversely, liabilities are any money you owe someone else. Any bills that you haven’t paid, credit card balances, lines of credit, short- or long-term loans, etc. This is all money that is owed to another person, vendor, bank, or business. Having high liabilities can push you toward negative net worth. Even though these seem like negatives in our minds, all numbers are listed in the positive on the balance sheet (this can get confusing when there are true negative credit accounts, but we won’t go there for now).
Finally, we have equity (aka owner’s equity). The accounts here vary in type and name depending on your entity (how you file your business taxes…consult with a CPA if you’re unsure or if you think it’s time to revisit this conversation), but they basically all behave the same way. This section of the balance sheet contains several important pieces of information:
Shareholder Contributions. How much money owners (aka partners/shareholders/investors/you and your family) have contributed to the business. This is called many things; paid-in capital, capital stock, contributions from shareholders, cash infusion, etc. and is different from income. This is money put into your business NOT from operating activities, but due to infusing your own funds (or funds from shareholders) into the business. Many times you may do this to cover expenses when you don’t have enough cash in the bank.
Dividends. Money taken out of your business and provided to investors/shareholders/owners/partners. This too can have many aka’s: owner draw, partner A draw/partner B draw, distributions, etc. In a very small business, this account may reflect the amount an owner pays herself.
Retained Earnings. This is the business’ earnings over the course of its lifetime after all dividends/distributions have been paid out. It can also be called accumulated earnings. It’s similar to putting money in a piggy bank to save up vs. spending it on something you want now. It can be used much like an emergency fund or a means to invest in new assets, product development or marketing.
Net Income. The amount of revenue you’ve managed to hang onto at the end of an accounting period (month/quarter/year). When placed side by side with your Income Statement for the same period, the net income line will match the very bottom line of your income statement (net income/loss). When your fiscal year is over, this amount is rolled into your retained earnings (or subtracted out if you had a loss) and your net income starts over.
The biggest reason it’s called the balance sheet is because BOTH SIDES OF THE ACCOUNTING EQUATION MUST BALANCE. If they don’t, you’ve got problems on your hands. Using algebra (who knew I’d use this in the real world?), we can change the formula to read:
Assets – Liabilities = Owner’s Equity
Or we can say the stuff we have minus the stuff we owe equals what we own outright. This is also known as our Net Worth.
There are hundreds of ratios and equations that financial minds can put to the numbers in your balance sheet and income statement in order to make determinations about the health of your business (and whether or not investing in your company or loaning you money may be a smart or dangerous proposition). This is why it’s so important to ensure your numbers are correct and balanced.
Does your balance sheet balance? Are you a safe bet or a high risk? Feel free to reach out to us – we can help!
Until next time!
Part 1: The Chart of Accounts Explained
Part 2: The Income Statement Explained