What is a Balance Sheet and How do I Read It?

A balance sheet is an easy way to demonstrate the cumulative “net worth” of a business as of a certain date in time.  It details the assets, liabilities, and owner’s equity at a certain moment since the beginning of the business.  The balance sheet is just one of three important financial statements that owners, managers, and potential investors or buyers look at in order to assess the performance of your business.

The other two statements are:

The Income Statement (AKA Profit & Loss): this statement shows the income of the business and subtracts expenses.  The income statement shows income and expense activity over a specific period of time.  So, it could show your net income weekly, monthly, quarterly, or even yearly.

The Cash Flow Statement: The statement of cash flows depicts movements of cash or other valuable assets in and out of the business.  This statement is very useful if you are running accrual (more blog posts to come on this) Income Statements that do not necessarily show how cashflow is going.   This report is very useful for businesses that have to invest heavily in assets like inventory, machinery, or land.  It also shows how much the business is relying on financing to support operations.

Ok, back to the Balance Sheet.  The balance sheet is comprised of three main components: Assets, Liabilities, and Owners (Stockholder’s) Equity.  But those are all just accounting jargon so lets break it down.

What are my assets?

Assets are what you own and have available for use in the business.  They can be as straightforward as cash in the bank or as vague as goodwill.  Here’s a list of common assets we see in closely held businesses:

• cash on hand (The amount of accessible cash you can use without any wait)
• temporary investments
• accounts receivable (What customers owe you)
• inventory (Things you own that will be sold)
• prepaid expenses (things you paid for, but haven’t received)
• land & land improvements (under the assumption you could someday sell that land)
• buildings and equipment that have value

Now not all of these assets necessarily will be listed on a balance sheet.  Some of these assets are called intangible assets because, well, they’re difficult to assess.  For that reason, people in the accounting profession use GAAP (Generally Accepted Accounting Principles) which identify whether or not assets have market value before putting them on the balance sheet.  In most small, closely held businesses, GAAP rules are not necessarily followed and you tend to see assets that are easily valued… like cash in the bank.

What about Liabilities?

Liabilities are all the things that a business owes, all their outstanding loans, etc.  All businesses have liabilities, but its best to try to minimize outstanding liabilities for a successful business.  Some examples of liabilities that may show up on a balance sheet are:

• Accounts Payable (bills you owe your suppliers and vendors)
• Other Payables – Like sales tax collected that will be paid at a later time or payroll taxes that have been deducted from employee wages, but not yet paid
• Lines of credit, term loans, or credit overdrafts
• Credit card accounts with an outstanding balance

What is Equity?

Equity is essentially everything you have leftover after you combine the two above factors.  Equity is equal to assets minus liability. This is generally called the shareholder’s equity or owner’s equity dependent on if the company is a sole proprietorship of a corporation (with stockholders).  The equity is all of the:

• Paid-In Capital: the amount of assets that investors contribute. Investopedia has a good breakdown of different types of paid in capital if you want more information!
• Retained earnings: When a business turns a profit the owner can choose to either take out the money for themselves or they can reinvest that money back into the business. The money reinvested is the retained earnings. This article by The Balance points out that the definition of retained earnings can vary dependent on if your company has shareholders. For more information on the difference between owner’s equity and retained earnings check it out.

Some businesses are required to submit their balance sheets and other financial statements to investors, banks, management or other interested parties.  Even if you are not required to submit a balance sheet, however, it is a good idea to monitor your business through the use of these documents.

We send our clients balance sheets on a regular and recurring basis so that they can make better managerial decisions to improve their business.  Without this information, a business owner is essentially “flying blind” and may make decisions based on emotions and feeling rather than true business intelligence.  The balance sheet is an important component of that process but it doesn’t work if there is confusion over the accounting terminology!  At Accountix we want to make accounting accessible and make the number make sense so feel free to refer back to this guide as needed.