As a small business owner, it is tempting to rely solely on income (e.g. profit and loss) statements to gauge the performance of your company. Resist the temptation! Basing important business decisions on a snapshot of your overall picture could mean expensive mistakes or missed opportunities.
The balance sheet has been around for a long time, and for good reason. It helps fill in the gaps, or provide a fuller understanding, of the health of your business at a given point in time. Reviewing your balance sheet regularly will help you better manage your business, so use this article as a starting point (and motivation!) for learning how to read one.
The balance sheet is a statement that reflects the assets, liabilities and equity of a business or organization. The fundamental equation governing the balance sheet is:
Assets = Liabilities + Equity or Equity = Assets - Liabilities
Assets are the tangible or intangible things owned by a business. They are typically listed in order of liquidity and carry a debit balance. An asset could have a credit balance, which is called a contra asset - accumulated depreciation is one example.
Liabilities are debts or obligations owed by the business - they could also be thought of as someone’s (or some entity’s) claims against the company. Liabilities are generally listed in order of due dates and will carry credit balances.
Equity is the claim to, interest in, ownership or financial value of a company. Equity, or owner’s equity, is generally what is meant by the term “book value,” which is not the same thing as a company’s market value. Equity accounts normally carry a credit balance, while a contra equity account (e.g. an Owner’s Draw account) will have a debit balance.
Do you have the ability to meet current financial obligations? Another way to ask the same question is: how much working capital is currently in the company? You can determine the answer to that question by subtracting current liabilities from current assets.
The balance sheet can also tell you things like the length of your accounts receivable or inventory turnover cycle (i.e. the number of times they turn over over each year).
By dividing total liabilities by total equity, you can determine your debt to equity ratio to see how much of the business is supported by creditors versus owners.
By viewing the balance sheet with a comparable period, you will maximize the potential insight to be gained from these and other pieces of information.
Reading your balance sheet together with your income statement is essential to getting a fuller picture of your business. It may be helpful to think of the income statement as a financial explanation of what happens in the period of time between two balance sheets.
For example, if you made a payment on a business loan during a given month, the income statement for that same month could show an interest expense, while the balance sheet would change from the beginning to end of the month in at least two different ways: the loan (liability) account would decrease, and the cash (asset) account would decrease by the total payment amount.
In that simple scenario, if you were trying to understand business performance by looking solely at the income statement, you would only see an interest expense and its limited impact. The balance sheet, however, would inform (or remind) you that net income is higher than it would be if cash (i.e. your loan payment) had not decreased.
At a very basic level, setting up a cloud-based accounting system like Xero or Quickbooks Online is a fundamental step. If you’ve made it that far, keeping bank and credit card transactions reconciled weekly or monthly is essential. We have seen thousands (millions?) of unreconciled transactions - the further back in time they go, the more difficult and time-consuming it is to accurately account for them.
A practical accountability measure is to set a hard date by which your balance sheet (and other financial statements) must be closed each month.
How detailed are the accounts that appear on your balance sheet? Depending on your particular situation, multiple accounts could be consolidated or “rolled up,” in order to give you a cleaner and simpler look.
Having someone review or consult with you on your balance sheet structure and overall reporting framework will help you understand it better and turn it into a more valuable insight tool.