You need the right tools to manage your business.
One of the most important set of tools is your financial statements, including the balance sheet. Many business owners make the mistake of using an unclassified balance sheet to make decisions. A classified balance sheet provides far more detail, and you can use that detail to successfully manage your business.
To avoid making this mistake, you need to understand the differences between the two reports.
Balance sheet defined
A balance sheet is a snapshot of a company’s financial position, as of a specific date. The balance sheet lists a firm’s assets, liabilities, and owner’s equity balances for a month or year.
There are two other financial statements that are connected to the balance sheet. An income statement reports revenue, expenses and net income for a specific period of time. The net income balance in the income statement increases an owner’s equity in the balance sheet.
A cash flow statement lists the cash inflows and outflows for a month or year, and the ending cash balance is the same dollar amount reported in the balance sheet. If you create a June cash flow statement, for example, the June 30th cash balance in the cash flow statement equals the cash balance in the June 30th balance sheet.
Here are the components of a balance sheet:
- Assets – What your business owns. Assets are resources used to produce revenue.
- Liabilities – What your business owes to other parties. Liabilities include accounts payable and long-term debt.
- Owner’s equity – Owner’s equity is the difference between assets and liabilities, and you can think of owner’s equity as the true value of your business.
The components are connected by the balance sheet formula:
Assets = Liabilities + Owner’s Equity
Owner’s Equity = Assets – Liabilities
The formula is used to create the financial statements, including the balance sheet. Business owners must understand the differences between a classified and unclassified balance sheet, and why a classified balance sheet is far more useful.
Differences between classified and unclassified balance sheets
An unclassified balance sheet provides minimal information, and is not as useful as a classified balance sheet.
Unclassified balance sheets only report the total balances for assets, liabilities and owner’s equity. Classified balance sheets are more frequently used because they offer sub-categories that provide more detail to the financial statement reader.
Assume, for example, that Julie owns Centerfield Sporting Goods, a baseball glove manufacturer.
Click here is a look at Centerfield’s unclassified balance sheet for the period ending 12/31/2018.
The report simply lists total assets, liabilities and owner’s equity. The balance sheet notes that total liabilities plus owner’s equity ($185,000) equals total assets, and the balance sheet formula is in balance.
Small businesses, including firms that are just starting out, may generate an unclassified balance sheet. However, all companies should make the effort to produce a classified balance sheet, which is more useful to a business owner.
Classified balance sheet accounts
Click here to view Centerfield’s classified balance sheet for the period ending 12/31/2018.
The asset, liability and owner’s equity totals are the same, but this report provides far more detail that is useful for a business owner.
Here are the most common accounts listed in a classified balance sheet:
Asset accounts summarize what your business owns, and each asset account is defined as current or non-current.
Current assets include cash and assets that will be converted into cash within 12 months. Non-current assets will not be converted into cash within 12 months. The same categories apply to liabilities, as explained below.
Generally Accepted Accounting Principles (GAAP) requires firms to separate assets and liabilities into current and non-current categories.
Stakeholders, including investors and creditors, want to review financial statements that comply with GAAP. Your company should produce classified balance sheets, so that your results are comparable with other firms that use GAAP accounting standards.
- Cash: The total amount of money on hand.
- Accounts receivable: The amount that your customers owe you after buying your goods or services on credit.
- Inventory: Items purchased for resale to customers.
- Prepaid expenses: Expenses you’ve paid in advance, such as six months of insurance premiums.
- Investments: Money-market account balances, stocks and bonds. Some investments may be categorized as long term, but most are short-term assets.
- Notes Receivable: Amounts you are owed that will be paid within 12 months.
- Fixed assets: Fixed assets include vehicles, equipment and buildings used to produce revenue. These assets decrease in value over time. For that reason, depreciation expense is posted to record the decline in value of fixed assets.
- Intangible assets: Assets that have no physical manifestation, such as goodwill, patents and trademarks, fall into this category.
Liabilities are amounts owed to third parties.
- Current liabilities: These are amounts due to be paid within a year, such as accounts payable (amounts you owe suppliers), payroll liabilities and amounts due on short-term business loans, such as a line of credit.
- Long-term liabilities: Amounts due to be paid in a year or more, such as long-term loans, mortgage payments and future employee benefits. These liabilities are non-current, but the category is often defined as “long-term” in the balance sheet.
Centerfield’s classified balance sheet lists the current portion of long-term debt ($20,000) as a current liability. Any loan payments due within a year are current liabilities, regardless of the term of the loan.
Liquidity and solvency
A classified balance sheet allows a business owner to analyze liquidity and solvency.
Liquidity is defined as the ability to generate sufficient current assets to pay current liabilities, such as accounts payable and payroll liabilities. If you can’t generate enough current assets, you may need to borrow money to fund your business operations.
Solvency is another term that describes the financial health of a company. Your firm must be able to generate profits over the long term, in order to purchase expensive assets and make payments on long-term debt.
To monitor your company’s liquidity and solvency, you must use the current and non-current classifications in the balance sheet.
If you sold all of your company assets and used the proceeds to pay off all liabilities, any remaining cash would be considered your owner’s equity balance.
In a sole proprietorship, equity is defined as owner’s equity. In a corporation, equity is called stockholder’s equity, which may include common stock and preferred stock issued to shareholders.
Julie operates Centerfield Sporting Goods as a sole proprietor, and she uses an owner’s equity account to create the balance sheet. Assume also that 2018 is Centerfield’s first year of operations.
Equity may include:
- Opening balance equity: The owner’s initial investment into the company. Julie contributed $25,000, which is posted to owner’s capital in the classified balance sheet. This balance is the beginning balance in the equity account.
- Capital stock: The dollar amount of common and preferred stock a company issues to shareholders. Issuing stock increases the equity balance.
- Net income: Total revenue less expenses, for a month or year. Net income is calculated in the income statement, and the balance increases equity. Centerfield generated $10,000 in net income for year-end 2018.
Working with retained earnings
The retained earnings balance is the last component of an owner’s equity.
Retained earnings is calculated as total company earnings (net income) since inception, less all dividends paid to owners since inception. Firms can choose to retain earnings for use in the business, or pay a portion of earnings as a dividend.
Dividends reduce the equity balance.
Julie’s firm earned $10,000 in 2018, and no dividends were paid to Julie as the sole owner. Many owners, particularly in startups, choose to keep company earnings in the business to fund business operations.
The ending balance in retained earnings is $10,000.
The opening balance in equity, net income and issuing stock all increase the equity balance. If your firm pays a dividend to owners or generates a net loss, equity is decreased.
How to analyze a classified balance sheet
The classified balance sheet is a valuable tool to understand the financial health of your business and make more informed decisions. To illustrate, here are three frequently used financial ratios:
This ratio is defined as (current assets less current liabilities). Working capital reports the dollar amount of current assets greater than what’s needed to pay current liabilities, and financially healthy companies maintain a positive working capital balance.
Centerfield’s working capital balance as of 12/31/18 is ($140,000 – $50,000), or $90,000.
Julie’s large working capital balance allows Centerfield to take advantage of opportunities to increase profits. If the customer places an unusually large order, Centerfield has excess working capital available to purchase materials and pay employees to work longer shifts.
A business with a low working capital balance does not have financial flexibility, and growth is more difficult.
The ratio is calculated as (total liabilities / total equity), and this metric tracks increases and decreases in liabilities, as a percentage of equity.
If a company’s accounts payable and long-term debt balances are growing at a much faster rate than equity, the ratio will increase. An increasing ratio may be an indication that the firm is taking on too much debt and cannot make payments on all liabilities.
Centerfield’s ratio is ($150,000 / $35,000), or 4.28. The firm has $4.28 of debt for every dollar of equity, and whether your firm’s ratio is “good” or “bad” depends on the industry.
Businesses that need to spend big dollars on assets typically carry more debt. Banks are a good example, since the banking industry still relies on physical locations to drive business. To build locations, banks take on debt.
Julie just finished her first year in business, so it’s not surprising that her retained earnings balance is low. As time goes on, Centerfield may retain far more earnings, which will increase an owner’s equity and reduce the ratio.
Smart business owners compare financial ratios to industry averages.
Accounts receivable turnover ratio
If your sales are growing and you don’t collect accounts receivable dollars fast enough, you may run short on cash.
To avoid this problem, many owners analyze the accounts receivable turnover ratio:
(Net annual credit sales) / (Average accounts receivable)
Credit sales are sales to customers who don’t pay immediately. The “net” in net credit sales means that uncollectible receivable balances are subtracted from the total.
Average accounts receivable is the beginning plus ending balance for a month or year, divided by two.
The Centerfield balance sheet reports an ending 2018 accounts receivable balance of $70,000, and let’s assume that the average balance for 2018 is $60,000.
If net annual credit sales total $600,000, the ratio is ($600,000 / $60,000), or 10. The idea is to increase credit sales at a faster pace than the growth in accounts receivable.
It’s great to sell more, as long as you can collect receivables at a reasonable rate. Check this ratio each month to monitor the growth in accounts receivable.
All of these ratios use data from the balance sheet, and business owners analyze these ratios to assess company performance. Companies that generate working capital, manage debt and monitor receivables are better managed.
By keeping an eye on things, you’ll increase profits over time.
Actions steps to take
Make sure that you understand how a classified balance sheet is put together. If you use accounting software, use the report functionality to produce classified balance sheets.
Generate a classified balance sheet each month, and compare the report to recent months, so you can identify trends. Is the amount of working capital increasing each month? Is your debt balance increasing or decreasing?
The balance sheet is a great tool to identify trends and make business decisions based on those trends. Try using this free balance sheet template to perform your analysis.
Work with an accountant to decide which financial ratios are most useful for you, and use accounting software to generate the ratios each month. Analyze the financial ratios to assess your business results.
It’s difficult to know where your business is headed, but reviewing your monthly financials can help you find direction. Invest the time to review your classified balance sheet each month, and you can move forward with more confidence.