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FINANCE, BUDGETS AND CASHFLOW
A company’s balance sheet is one of several important financial statements that report on its performance. But to understand its importance, you need to understand the balance sheet formula and the types of accounts it uses.
Then you can download our balance sheet template and review some analytical tools to assess your business.
A balance sheet (or a statement of financial position) reports your company’s assets, liabilities, and equity as of a time period. Stakeholders need access to it, together with other financial documents, to evaluate your results.
Assets are what your business owns. They are the resources you use to produce revenue. Liabilities are what your business owes to other parties. These financial obligations include accounts payable and long-term debt. Equity is the difference between assets and liabilities. Think of equity as the true value of your business.
When you provide accurate financial reports and balance sheets, you can maintain good relationships with stakeholders. If financial performance declines, you can explain the changes you’re making to improve results. Stakeholders include employees, investors, creditors, regulators and vendors. Business owners must keep stakeholders informed for a variety of reasons.
Investors want to know if the business is generating profits, which may increase the market value of the stockholder’s equity
Creditors need to know if the company is generating enough cash to repay borrowed money
Vendors want to know if the business will continue to order goods and services, and that the business can pay invoices on time
The balance sheet equation calculates assets by adding a business’s liabilities and equity together. This formula is also called the accounting equation. The balance sheet formula is as follows:
Liabilities + Equity = Assets
Accountants use the formula to create financial statements. So each transaction you post to your accounting systems must keep the formula balanced.
Let’s say a business issues a £10,000 bond and receives cash. The company posts a £10,000 debit to cash (an asset account) and a £10,000 credit to bonds payable (a liability account).
The company would post a £10,000 increase in liabilities and a £10,000 increase in assets on the balance sheet. There would be no change in the company’s equity, so the formula would stay balanced.
If every transaction you post keeps the formula balanced, you can generate an accurate statement of financial position. But note that each section of the document may contain several accounts.
The assets and liabilities sections of the balance sheet separate accounts into current and non-current categories. The equity section, however, does not use current or non-current accounts. Assets are resources that a business uses to generate revenue and profits. Your assets may be tangible, such as equipment, or intangible, such as patents.
Asset accounts post in order of liquidity, so assets that convert to cash easiest come first. Cash and cash equivalents (eg. money market account balances) are listed first, followed by current assets. Land, buildings and long-term investments are listed last.
This category includes cash and assets that convert into cash within a year. For example, you can expect accounts receivable and inventory balances to convert to cash over months. Common current asset accounts include:
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 you purchase for resale
Prepaid expenses: Expenses you’ve paid in advance, such as six months of insurance premiums
Investments: Some investments, such as bonds, may be categorised as long-term assets, but most are short term
Bills receivable: A loan to an outside party that you’ll repay within 12 months
Non-current assets will not convert to cash within a year. Your business may own fixed assets and intangible assets. Some balance sheets refer to non-current assets as long-term assets. Non-current assets include fixed assets, land and intangible assets.
Fixed assets include vehicles and equipment you use to produce revenue. These assets decrease in value over time. A depreciation expense records the decline in the value of a fixed asset.
Land goes in the non-current asset category, but the cost of the land doesn’t depreciate.
Intangible assets have no physical manifestation – think goodwill, patents and trademarks.
Assets convert into cash to pay liabilities. Liabilities are amounts your business owes to third parties. There are two types of liabilities: current and non-current (long-term) liabilities.
Current liabilities include balances that your business must pay within a year.
Accounts payable: This includes bills that you owe to vendors that you must pay within a year.
Current portion of long-term debt: This includes what you must pay within 12 months. If you owe £3,000 in principal and interest on a bank loan within a year, the amount is classified as a current liability.
Customer deposits: If a client deposits money before you deliver a product or service, the cash deposit is a liability. You must repay the customer if you don’t deliver the goods or services.
Non-current liabilities are amounts your business must pay within a year or more. The non-current category includes long-term debt like loans and mortgage payments. The current portion of long-term debt is a current liability.
Imagine that you sell all of your business’s assets for cash. You might use the cash to pay off all of your accounts payable balances and your long-term debts. Any cash remaining is your equity, which is the true value of your business.
Equity measures a company’s net worth. You may see equity defined as ‘shareholder’s equity’ or ‘owner’s equity’. This category includes ordinary shares, additional paid-in capital and retained earnings.
“Par value” is a pound amount used to allocate pounds to the ordinary share category. For example, assume that a company issues 1,000 shares of £1 par value ordinary share. Investors purchase the 1,000 shares and pay £5,000. In this example, the ordinary share balance is £1,000 (1,000 shares of £1 par value).
Additional paid-in capital is the amount of money shareholders invest that is greater than the ordinary share balance. The additional paid-in capital balance is £4,000, or £5,000 subtracted from the £1,000 ordinary share balance. When the company starts generating profits, their transactions will be categorised as retained earnings.
Retained earnings are the sum of total company earnings (net income) since inception minus all dividends paid to the owners since the firm’s inception. Businesses can choose to retain earnings for use in the business or pay a portion of earnings as a dividend.
Data in the statement of financial position connects the profit and loss account and the cash flow statement.
A profit and loss account reports a company’s profit or loss for a time period. It’s a financial statement that subtracts revenue from expenses to determine net income or profit. The formula is as follows:
Revenue - expenses = net income
Net income increases the equity on the balance sheet. Many business owners focus on the statement of financial position and the profit and loss account, but the cash flow statement is equally important.
The cash flow statement reports cash inflows and outflows over time. You can separate cash flows into three activities: operating, investing and financing. The ending balance in the cash flow statement must equal the cash balance on the balance sheet.
Overall, the statement of financial position is one of three financial statements that explain your company’s performance. Review yours monthly, and use analytical tools to assess your financial performance. Balance sheet data can help you make better business decisions and increase profits.
We hope you’ve found this article useful. QuickBooks is there to help small businesses and self-employed people get their finances right.
Learn more about finance, budgets and cash flow on the Quickbooks blog.