The Balance Sheet provides a snapshot of a company's financial position - what the company owns and what it owes - at a particular point in time, often at the end of a month, quarter or year.
Business owners, investors, and lenders use the Balance Sheet to assess a company's financial strength and capabilities.
The Balance Sheet is one of the three main financial statements, along with the Income Statement (aka the Profit & Loss Statement) and Statement of Cash Flows that should be reviewed regularly.
The Balance Sheet, along with the Income Statement, are the most important tools used to make decisions that will impact the trajectory of a business. Since you want your business to scale forward and/or up, the Balance Sheet is an important financial statement to focus on!
Let's zoom in to take a closer look at what it's all about.
(To find this report in QuickBooks Desktop: Reports > Company & Financial > Balance Sheet Statement. For QuickBooks Online: Reports > Balance Sheet.)
The Balance Sheet includes three sections: Assets, Liabilities and Owner's Equity.
The basic accounting equation represents the relationship between these sections:
Assets = Liabilities + Owner's Equity
The equation must always stay in balance (hence the name, Balance Sheet). Therefore, if the left side of the equation increases, there must be an increase on the right side in order for the equation to stay in balance. Conversely, if there is a decrease on the left side of the equation, there must also be a decrease on the right side.
Increasing one asset and decreasing another by the same amount can also keep the equation in balance. Similarly, an increase to a liability or owner's equity with a decrease of the same amount to a liability or owner's equity will net zero, keeping the equation balanced.
Take a look at the perfectly balanced sheet below. You can see that the amount of Total Assets on the left side is exactly equal to the amount of Liabilities and Equity on the right side.
Now, let's focus on each item in each section of the Balance Sheet.
Assets are the possessions of the business. An asset is categorized based on how quickly it is expected to be turned into cash, sold, or consumed.
Current or Short-Term Assets
These are assets that you expect to convert into cash within one year.
Examples of Current Assets are:
- Cash - actual cash, checking and savings accounts
- Accounts Receivable - products or services you've provided to customers. You have billed the customer, but they have not yet paid.
- Prepaid Expenses - leases, insurance
- Inventory - goods available for sale, as well as the raw materials used to produce those goods. Manufacturing and packaging supplies are also included.
These are assets that you will hold for more than one year. They provide long-term value to your business.
Examples of Long-term Assets include:
- Fixed assets - land, buildings, equipment, vehicles
- Accumulated depreciation may be subtracted from this as the useful life of the asset is expended
- Investments - stocks, bonds, real-estate investments, certain cash vehicles
- Intangible assets - goodwill, copyrights, trademarks, patents
These are obligations or money owed to outside parties. Similar to assets, they are categorized based on the time frame over which those obligations will be repaid.
Short-term or Current Liabilities
These are amounts that you will pay within one year.
- Accounts Payable - owed to vendors for products or services they've provided to you, often due within 30 days
- Credit Cards
- Salaries/Wages Payable - accrued for hours worked, but not yet paid
- Taxes Payable - often paid quarterly to federal, state and/or local governments
- payroll taxes - federal, state, Social Security, Medicare, unemployment
- sales tax from sales of goods or services
- Notes Payable/Short-term loans
- Loans on vehicles, equipment
- Deferred compensation, revenues, taxes
Rearranging the basic accounting equation can help us understand Owner's Equity a little more clearly.
Owner's Equity = Total Assets - Total Liabilities
In personal finance, this would be considered a person's net worth.
In a business, it's how much stake or share the owner has in the business.
Owner's Equity includes:
- Capital Stock - issued to investors
- Retained Earnings - the accumulated yearly net income (or loss) from when you first started your company. In other words, you have "retained" or reinvested these funds in your business. You've already paid taxes on this amount, so it's all yours!
- Shareholder Distribution - payments of cash, stock or physical product made to a shareholder
- Net Income/Loss - the year-to-date amount of income minus expenses (from your Income Statement)
Typically, this number is a positive number. However, if liabilities are greater than assets, then owners equity is negative. The owner may need to invest additional money to cover the shortfall, or look for shareholders to invest.
Owner's Equity is the least understood and most commonly ignored section of the balance sheet, but arguably, the most important! We dig deeper into Owner's Equity in this post.
As we discussed before, the equation must always stay in balance. Let's say that you made a $2500 payment on the payroll liabilities. The new payroll liabilities amount would be $2,904.45 and checking would decrease by $2,500 to a balance of $44,969.10. The total amount balance at the bottom of each column would be $632,533.93. Look below - our sheet is still in balance!
It's important to know where each number on your balance sheet comes from. Understanding how increases or decreases in one area of the balance sheet affect another is important in understanding how to use this tool to make decisions.
Just like a photo, your balance sheet has the ability to tell a story. Once you have the basics down, you can use the information to analyze how your business is doing. Check out these three important analyses for a clearer picture of the health of your business. Knowing these important ratios will help you to take steps to ensure its financial well-being in the future.
As always, contact us if you have any questions regarding your Balance Sheet. We're happy to help!