What's a balance sheet?
Last time we discussed the main parts of a Profit and Loss Statement (P&L), and how they can help you see your business in a different light. The next report in the pantheon of small business financial documentation I want to discuss is the Balance Sheet. Like the P&L, the Balance Sheet is used to report key financial information to management and shareholders, providing a snapshot of the business as a of a specific date.
Understanding a Balance Sheet isn't too terribly complex (though the insights gleaned can be very powerful). Essentially, a Balance Sheet is represented by this simple equation:
Assets = Liabilities + Equity
Assets: All the stuff the business owns, or is owed.
Liabilities: All the stuff the business owes.
Equity: How much money investors have put into the business plus profit the business decides to keep after dividends have been paid out.
Here's an example of what a Balance Sheet looks like:
One of the best things about financial documents is that the name usually tells you what you need to know. In this case, the right and left side of the Balance Sheet need to be equal. You may be asking, "How can the assets and liabilities always match?" That's a great question. The answer is that they rarely do, which is why the concept of Equity is in the Balance Sheet. If there are more liabilities than assets, then the shareholder equity could be negative, and the opposite is true, too.
There are two types of assets: current and fixed (in this example called "Non-current"). Current Assets are anything that will be used within 1 year of the date of the Balance Sheet. In this example, Cash, Accounts Receivables, Supplies, and a few cash equivalent products (prepaid rent and insurance) are being considered current assets. This business plans on using all these assets within 1 year. Fixed assets are, by definition, all the other things the business owns but will not be readily converting to cash: equipment, real estate, vehicles, etc. (less depreciation).
On the left side of the Balance Sheet these assets are totaled up and represent the sum total of the assets of the business.
Similar to assets, liabilities are broken up into two categories: current and long-term (FYI, this example doesn't have any long-term liabilities listed). Current Liabilities represent money the company will have to pay out within 1 year of the date of the Balance Sheet. Loans, accounts payable, employee pay that hasn't been paid out yet, are all common current liabilities that most businesses have. Long-term liabilities are payments that will come due more than 1 year out from the Balance Sheet date. Common long-term liabilities are bond payments, and balloon payment loans.
Equity is the amount initially invested by shareholders plus Retained Earnings (the amount of money the company earned after paying out dividends to shareholders). If, for instance, no dividends were paid out, then all the retained earnings would go to the right side of the Balance Sheet. At a basic level, in a healthy company, the total equity represents the "value" of the business. If one were to liquidate all the assets, pay off all the liabilities, and give all the shareholders their money back, the retained earnings would be the money left over to divvy up to shareholders.
So, What Does This Mean?
For starters, the Balance Sheet directly relates to the Profit and Loss Statement, because the retained earnings that pop up on the Balance Sheet is a function of the Net Profit from the bottom of the P&L. So, taking these two documents together, you can see not only how profitable your company is, but also how valuable it is, and whether you're asset or liability heavy.
There are also two key metrics you can glean from the Balance Sheet: working capital and debt-to-equity. Working Capital is calculated by simply subtracting current liabilities form current assets. This gives you a good idea of how "liquid" your company is and whether or not you can expect short term financial issues. The Debt-to-Equity ratio is calculated by dividing your company's total debt by the shareholder equity. Like a Debt-to-Income ratio used in home lending, this ratio shows you how much your business is being financed through debt versus cash or other wholly-owned funds.
It may appear simple, but as you can see the Balance Sheet is a powerful tool for understanding the short and long term health of your business. Next week, we're going to discuss the last of the key financial reports every small business owner should understand, the Cash Flow Statement.
If you'd like to learn more about how to read financial statements and gain key insights from them, reach out to us for a free business evaluation.