If you’re a business owner that has no idea what a balance sheet is trying to tell you, you’re not alone.
Accountants love this report, and bookkeepers are content when all of the account balances—especially cash—line up and match the way they should on your books. But that still doesn’t tell you why a business owner should get so excited about a balance sheet.
Instead of staring blankly at your statements, here’s a basic primer on balance sheets to help you better understand their construction and usefulness.
The Magic Formula
Don’t worry, you don’t have to understand that debits are by the door and credits are by the window. (Or do I have that backwards?) Fortunately, there is an underlying formula that explains how the three major parts of a balance sheet are related:
Assets – Liabilities = Equity
This basic equation calculates owner’s equity, or the amount of ownership the proprietor has in the business and other assets; in corporate balance sheets, this may also be referred to as “shareholder’s equity.”
With this equation as the foundation of your balance sheet, let’s take a look at each element and how they apply to your business’ finances.
1. “Assets” Are What You Own
The simplest aspect to understand when creating and evaluating balance sheets is “assets.” Assets are properties your business owns. This can include “current” assets, which are properties that can be converted into cash within a year, as well as “fixed” assets, which are properties that typically take more than a year to convert to cash.
If you own equipment, furniture, cars or trucks, or something similar that lasts for years, you will have to account for these in a fixed-asset balance on your statement. If it’s been a while since you’ve purchased these assets, you may have a depreciation account, and when you net the two, your fixed-asset values are reduced.
Most balance sheets start off with cash balances, and these typically represent the capital in your bank account less any uncashed checks that could reduce your account once they come in. If customers owe you money that you have invoiced but not yet collected, you might see an accounts-receivable balance on your balance sheet. If you sell products, the cost of goods you produce and maintain but have not yet sold will be your inventory account.
All of the above are assets, and they are listed in the first section of a balance sheet.
2. “Liabilities” Are What You Owe
If you owe money for taxes, to vendors or to employees, it should be accounted for in the liabilities section of your balance sheet.
Unpaid day-to-day bills are also liabilities and should be represented in an accounts-payable account. Also, every bank loan your company is paying should have its own separate account, which will represent the principal owed on each loan; interest owed on these loans, however, should go in another place.
3. “Equity” Is Ownership
The final section of the balance sheet is equity. This is the section that will vary the most depending on the type of entity your business is set up as.
For example, if your business is a corporation, there will be a common-stock account that represents the original amount of money you put into the business; it will match the Articles of Incorporation that you drew up when the business was incorporated. This amount will rarely change (if ever) during the life of the business. There is also usually an account called “additional paid-in capital,” which is how much additional money you’ve put in or taken out of the company beyond the common-stock balance. And corporations will also have a retained-earnings account, which reflects accumulated profit (or loss) throughout its years of operation.
If your business is set up as a partnership, the equity section will include an account for each partner that represents their balance in the firm, which is the net amount of money they have put into the business over the years plus or minus their accumulative business income or loss.
And if your business is set up as a sole proprietor, you will see “owner’s equity” and a “draw account” in your balance sheet. When you take money out of the business, it is reflected in the draw account.
It’s All About the Timing
There is a lot more to the balance sheet. For example, bankers care about whether your assets and liabilities are current or long-term, and this will add more complexity to subsections within the balance sheet.
But for now, let’s cover one more item related to timing.
The balance sheet represents one date in time. The figures represent balances, and since the balances change daily, a balance sheet only represents one point in time. This contrasts with an income statement, which covers a period of time and has a “from” date and a “to” date, such as one month or a year. This is important to know when evaluating balance sheets.
Hopefully this guide will give you a better understanding of the accounting principles that govern your business’ finances. With the basics as a foundation, business owners can get more comfortable with statements, bookkeeping and accounting. Who knows? You may even be able to give your accountant a few pointers in the future!