Balanced books may not be sexy, but they provide small business owners with the grounding they need to make smart forecasting decisions about expanding their business, making large purchases, or hiring new employees. While the language of accounting professionals can be intimidating — especially if you’re the type of person whose financial record keeping consists of handing a box of receipts to your tax preparer once a year — don’t despair.
What might seem like an overwhelming task really isn’t so bad if you break it down into a few simple steps. Here, we’ll outline those steps and explain what you need to know to get started so that you can get on with the business of, well, your business.
Before you get started balancing your books, you first need to decide what type of accounting system you’re going to use: cash accounting or accrual accounting. The type of system you decide on will determine the financial statements and tools you need to manage your small business.
A cash accounting system tracks cash flow as it enters and leaves your business in real time. Under this method, accounts receivable and accounts payable aren’t recorded because they represent future transactions. With cash accounting, financial professionals will use a cash flow statement to record the financial health of your business over a certain period of time — whether a quarter or a year.
If your company uses accrual accounting instead of a cash flow statement, you will use a profit and loss statement (P&L) — also known as an income statement — to track your small business’s financial health. This document tracks things like a company’s revenue, expenditures, cost of goods sold (COGS), gross margin, and profit.
A P&L statement also lists all the accounts payable and accounts receivable for your business. As a result, it gives you the opportunity to review your company’s net income, which is essential for making sound business decisions.
Whether you use cash accounting or accrual accounting, there is one financial document every small business needs to succeed: a balance sheet. While a cash flow statement examines the flow of cash in and out of your business, and a P&L statement documents sales and expenses during a specific time, the balance sheet provides you with your company’s net worth.
What’s on a balance sheet
How do you arrive at this magical net worth calculation? Well, at the most basic level, you only need to understand three words: assets, liabilities, and equity. Throw in some simple addition and subtraction, and you’ve balanced your books. But before we get into the math, let’s define the variables.
Your company’s assets are what it actually owns and are usually broken down into two categories: current assets and fixed assets. Your current assets include things like cash, accounts receivable, inventory, prepaid expenses, and notes receivable. Fixed assets, on the other hand, include things that are less liquid, such as vehicles, furnishings, buildings, and land. When you add the cash value of the two together, you arrive at your total assets.
Liabilities, put simply, are your company’s debts. There are two types of liability: current and long-term. Current liabilities are debts that are due to be paid within one year. These might include balances on business credit cards, wages payable, and sales tax due at the end of your defined accounting period. Meanwhile, long-term liabilities are debts that won’t come due for more than 12 months, which might include notes payable and mortgage payments on any company-owned real estate. When you add the two together, you get your total liabilities.
Finally, your equity — also known as capital or net worth — is what your balance sheet will ultimately track. This number is crucial to your business, as it shows how much capital actually belongs to your business. To balance your books at the end of the month, you only need this simple equation:
Equity = Total Assets – Total Liabilities
If your assets are greater than your liabilities, your business is financially stable.
How to create a balance sheet
Now that you know what should be on your balance sheet, how do you actually create one?
Well, your first task is to choose your accounting period. Most businesses balance their books for each calendar month or each quarter. When you are new to the process, balancing your books each month will make the task more manageable.
If you use a cash accounting system, as many small-business owners do, and you want to start at the most basic level, you can simply write two columns of numbers on a piece of paper: assets on one side and liabilities on the other. Total each column, subtract liabilities from assets and the resulting number should equal your business equity.
Accounting and bookkeeping software like QuickBooks can simplify your bookkeeping, since most banks will allow you to download account information directly into the program. After you load the data, your only task is to review the entries and make sure each one is tagged with the correct category. Keeping a separate business bank account makes this process easy and efficient.
How to balance your books
When you subtract liabilities from assets, the resulting number may not initially equal the equity you have in your business. In fact, it could be radically different. This might seem like a good time to throw in the towel. But don’t give up yet.
You are at the stage of balancing your books that accountants call creating a trial balance. This shows you whether there are any mistakes in your recordkeeping so you can rectify them, which is much easier to do at the end of the month or the quarter than the end of the year. Even seasoned professionals expect to make corrections at this stage.
To uncover errors, first check whether you forgot to record an entry in either column or listed the same entry twice. If not, try looking for a couple of common accounting errors. If the discrepancy is divisible by nine, it could mean you have transposed two digits. When two numbers are transposed (for example 850 instead of 580), the difference is always divisible by nine. If the discrepancy is a multiple of 10 (100, 1,000, etc.) there might be an addition or subtraction mistake in one of your columns.
While it may be tedious to rectify errors made while recording financial transactions, it is well worth the effort. Once you’ve corrected the errors in your books and gotten them to balance, you are truly in charge of your business — and ready to enjoy the benefits.
Why you need to balance your books
There are many benefits to keeping your books balanced. When you maintain an accurate bookkeeping system, you’re able to quickly understand the financial health of your business.
If your business is thriving, that means the sum of its assets is greater than the sum of its liabilities, which creates value in your company’s equity — or stock — and could open up new opportunities for financing. If your balance sheet shows your business’s net worth has consistently grown over time, you’re more likely to qualify for a small business loan to finance future growth. Alternatively, private investors may take an interest and buy your stock.
But there are other benefits to implementing an accurate bookkeeping system, such as knowing whether you have the opportunity for growth. Let’s say Maggie owns a small pet-sitting company and is looking to buy a larger piece of property in order to expand her business. Using her balance sheets from past quarters, she can compare numbers from the first and third quarters of the year, and determine if she has the capital available — or equity — to make a down payment on a piece of real estate.
Also, once you start balancing your books on a regular basis, you can start to see trends. In Maggie’s case, she can also see if there are fluctuations in her business — perhaps she tends to get more business in July and August as dog-owners take vacations in the summer months. That way, if she experiences a slight decrease in demand for her services in May and June, she knows her business is still on track for annual growth.
Stay balanced and poised for growth
Whether you choose to balance your books using accounting software, small business bookkeeping services, or a combination of both, understanding how the process works is a critical skill. After all, smart entrepreneurs know that even if accounting isn’t in their job description, ensuring healthy financial management of their business is crucial for a profitable bottom line.