Demystifying the Balance Sheet
A balance sheet, also called a statement of financial position, is a financial statement used in tandem with a profit and loss statement and a statement of cash flows. You need to take all three statements into consideration when making any assessments or decisions about your company. One statement alone does not “tell the story”. For this article, we’ll focus on the balance sheet only.
What is a balance sheet? Simply stated, a balance sheet is a list of all your asset, liability, and equity accounts. I’ll define those accounts in a moment. The amount of total assets should equal the total amount of your liability and equity accounts combined. They should balance. But, that’s not why this report is called a balance sheet; it’s called that because it reports the balance of each account as of a certain date, usually the last day of the month. Balance sheets represent a snapshot while a profit and loss statement and statement of cash flows cover a period of time.
What should I initially look for? The first thing you should do with your balance sheet is ensure that, in fact, the total assets equal liabilities and equity combined. If they are out of balance, troubleshooting will be required to find out the reason and correct the problem. The second thing you should do is note the balance of the retained earnings account in the equity section and compare it to your year-to-date profit/loss. They should be the same number. If not, that could be one of the reasons your balance sheet is out of balance.
What are assets? The accountant’s definition of an asset is a probable future economic benefit. The word “probable” is used because accountant’s are inherently skeptical and don’t believe in sure things. For example, your accounts receivable balance represents what customers owe you at that point in time. It is “probable” that your customers will pay their invoices, but there’s always a chance one or more might not. There are two major asset categories: current and non-current. Current assets are items where you will experience the economic benefit in less than a year. If it’s more than a year, they are classified as non-current. A subcategory of non-current assets are fixed assets: property, plant, and equipment. With the exception of land, fixed assets are depreciated. Another subcategory of non-current assets are intangible assets. As the word suggests, intangibles are items you can’t see, smell, taste, or touch but have some kind of value. Examples would include patents, copyrights, and goodwill. In most cases, the value is an estimate. In the traditional layout, assets are listed in order of liquidity: most liquid to least liquid. Liquidity means how quickly the asset can be converted to cash. Since cash is already cash, it is customarily the first account listed on the balance sheet. Accounts receivable is usually second with most customers paying within a 30-day time period.
What are liabilities? Liabilities, conversely, are probable future economic obligations – you owe money. Similar to assets, they are classified as either current or non-current, with the one year test being the deciding factor. Typical current liabilities include accounts payable, deferred revenue, and accrued expenses. A typical non-current liability is a debt that is due more than a year from the balance sheet date.
What is equity? Equity is the money invested into the business and the life-to-date income/loss of the company. For sole proprietors, the equity section is usually short – the money the sole proprietor has put into the business and income/loss. For large companies (especially publicly traded ones), the equity section could include stock that’s been issued and sold to investors.
What does it all mean? Using the balance sheet standalone, it means little. As mentioned above, all three financial statements should be examined simultaneously to “tell the story” properly. What it does tell you, however, is how much you have, how much you owe, how much you’ve invested in the business, and how much you’ve made.
What else can I do with it? There are several financial ratios you can calculate to establish metrics and monitor your company’s well-being. Use your favorite search engine and type “financial ratios” in the search bar. There are numerous resources on the subject which will define each type of ratio and how to calculate it.
I hope this article gives you a better understanding of a balance sheet. Comments and questions are always welcome.