HOW TO READ & UNDERSTAND A BALANCE SHEET
In the last article, we discussed the P&L statement which shows the comparison between income and expense and the balance resulting in gross profit. The second financial statement we are going to look at is the balance sheet.
WHAT IS A BALANCE SHEET?
A balance sheet is meant to convey how much a company is worth, by adding up the company’s assets and subtracting the liabilities resulting in the balance which is called the owner’s equity.
This figure is then used by investors, lenders, or prospective buyers to determine the value of the business by using certain factors that are determined by the industry and like sales. When the balance sheet is reviewed internally, it is designed to provide information on whether the company is moving in the right direction. It will allow management to shift the direction of the company to provide a better path towards growth and success.
On the other hand, if the balance sheet is being reviewed by a lender or investor it can provide information on the resources available to business for financing and growth.
External auditors, on the other hand, might use a balance sheet to ensure a company is complying with any reporting laws it’s subject to. It can provide information on the available liquidity of the company and how it can be leveraged quickly. The important factor to remember here is that the balance sheet is only accurate to a specific point in time, it can not predict the future.
THE BALANCE SHEET EQUATION
The information found in a balance sheet will most often be organized according to the following equation: Assets = Liabilities + Owners’ Equity
A balance sheet should always balance. Assets must always equal liabilities plus owners’ equity. Owners’ equity must always equal assets minus liabilities. Liabilities must always equal assets minus owners’ equity.
If a balance sheet doesn’t balance, it’s likely the document was prepared incorrectly. Typically, errors are due to incomplete or missing data, incorrectly entered transactions, errors in currency exchange rates or inventory levels, miscalculations of equity, or miscalculated depreciation or amortization.
Here’s a closer look at what’s typically included in each of those categories of value: assets, liabilities, and owners’ equity.
- Assets – anything that is owned by a company and holds inherent, quantifiable value. A business could, if necessary, convert an asset into cash through a process known as liquidation. There are two categories of assets which are classified as current assets and noncurrent assets.
Current assets typically include anything a company expects it will convert into cash within a year (short term), such as:
- Cash and cash equivalents
- Prepaid expenses
- Marketable securities
- Accounts receivable
Noncurrent assets typically are assets that will are not expected to be converted within the current year (long-term investments) such as:
- Intellectual property
- Equipment used to produce goods or perform services
- Liabilities – is something a company owes. Liabilities are any type of obligation to pay an amount of money to a debtor (business debt – debt incurred during the course of doing business).
Liabilities are also categorized as current or noncurrent.
Current liabilities (short term – expected to be paid off within the year) include:
- Payroll expenses
- Rent payments
- Utility payments
- Debt financing
- Accounts payable
- Other accrued expenses
Noncurrent liabilities (long-term – not expected to be paid off within the year)…
- Bonds payable
- Provisions for pensions
- Deferred tax liabilities
Liabilities may also include prepaid obligations to be provided in the future.
- Owners’ Equity – The amount that remains after all liabilities are accounted for. This is for the benefit of the owner or shareholders. This includes money invested into the business in exchange for ownership (in small business it is the contribution by the owner to start the business or provide additional cash to cover expenses or company investments. The additional inclusion is business retained earnings (profits) that the company has made over time.
A BALANCE SHEET EXAMPLE
By looking at the sample balance sheet below, you can extract vital information about the health of the company being reported on.
For example, this balance sheet tells you:
- The reporting period ends November 30, 2018, and compares against a similar reporting period from the year prior
- The company’s assets total $60,173, including $37,232 in current assets and $22,941 in noncurrent assets
- The company’s liabilities total $16,338, including $14,010 in current liabilities and $2,328 in noncurrent liabilities
- The company retained $45,528 in earnings during the reporting period, slightly more than the same period a year prior
***********Pic taken From Harvard Business Site
It Takes More
The information found in a company’s balance sheet is only a piece of the puzzle for a business owner to grasp what is happening with their business. Financial statements how a time in history about the business and lenders, and investors will accept this as a powerful tool to base decisions on. But for the owner of the business, it takes having a much deeper understanding to make rational decisions on the future direction of the business.
The statistics show that only 30% of small businesses use a professional accounting form and this is what contributes to so many small businesses failing within the first 5 years. The other problem is that many bookkeeping or/and accounting firms may be discounted and not provide the in-depth services that the small business needs. An accounting firm should be partnered with a small business and share the same goals that the business owner does to grow the business. An accounting service should also allow the business owner to concentrate on the front end of the business doing what he or she is the best at.