This article is part of a series of articles that will explain the key components of the financial and operational planning process for small businesses. This is the fourth article in the series and will explain the next element of the financial plan: the balance sheet.
Balance sheet (or Statement of financial position)
Your balance sheet is a snapshot of your business’s financial position. It demonstrates where your business stands, in financial terms, at a specific point in time --- how are you doing financially? How much cash do you have in the bank, how much do your customers owe you, and how much do you owe your vendors?
The balance sheet is standardized, and consists of three types of accounts:
- Assets are financial resources that are owned by your business and are expected to benefit future operations (cash, accounts receivable, inventory, etc.).
- Liabilities are financial obligations or debts. They represent negative future cash flows for your business and represent a claim against your business assets. The person or organization to whom the debt is owed is called a creditor (accounts payable, credit card balances, loans, etc.).
- Equity represents the business owner’s claim on the assets of the business. Because liabilities or creditors’ claims have legal priority over those of the owners, owners’ equity is a residual amount. That is, as the owner of the business, you are entitled to the assets that are left after the claims of the creditors have been satisfied in full. Therefore, owners’ equity is always equal to total assets minus total liabilities. To clarify, owners’ equity does not represent a specific claim to cash or any other particular asset. Instead, it is your overall financial interest in the entire business (for most small businesses, this is just shows as owner’s equity, but it could include investors’ shares, retained earnings, stock proceeds, etc.)
The core characteristic of the statement of financial position (or balance sheet) is that the total for assets always equals the total liabilities plus owners’ equity. This agreement or balance of total assets with the total liabilities and owner’s equity is the reason this financial statement called a balance sheet -- it’s the fundamental principle of the accounting equation:
Assets = Liabilities + Equity
You may ask, but why do total assets equal the total liabilities and owners’ equity?
The totals on the two sides of the balance sheet are always equal because they represent two views of the same business. The listing of assets shows us what things the business owns; the listing of liabilities and owners’ equity tells us who supplied these resources to the business and how much each group (creditors and owners) supplied. Everything that a business owns has been provided to it either by creditors or by the owners. As a result, the total claims of the creditors plus the claims of the owners always equals the total assets of the business.
Every business transaction, no matter how simple or how complex, can be expressed in terms of its effect on the accounting equation. At the end of the accounting year, your total profit or loss adds to or subtracts from your retained earnings (a component of your equity). As a result, your retained earnings is your business’s cumulative profit and loss since the business’s inception.
Components of a balance sheet
Typically, a balance sheet is divided into three main parts:
Current assets are those that can be converted to cash within one year. They typically include cash, stocks, accounts receivable, prepaid expenses, and inventory.
Fixed assets are tangible assets that are for long-term use, such as equipment, machinery, vehicles, land and buildings, furniture and fixtures, and leasehold improvements. Many other assets don’t fit within either of these categories, so most balance sheets include an “other assets” category for these items—typically things like long-term investment property, life insurance cash value, advances to employees and patent rights.
Current liabilities are business obligations due within one year. These typically include short-term notes payable (including lines of credit and credit cards), current maturities of long-term debt, accounts payable, accrued payroll and other expenses, and taxes payable.
Long-term liabilities are business obligations that are due outside of one year, such as any bank debt or shareholder loans with maturities longer than one year.
3. Owner’s equity
This is the sum of all owners’ money invested in the business and accumulated business profits. Owner’s equity may include owner’s contributions, common stock, owner’s draws, dividends, retained earnings, and paid-in-capital.
How to use the balance sheet
Your balance sheet can provide valuable insights and information to help improve your financial management efforts. For example, you can determine your company’s net worth by subtracting your balance sheet liabilities from your assets.
More importantly, you can use your balance sheet to alert you to upcoming cash flow shortages. For example, after a highly profitable month or quarter, business owners sometimes can get a false sense of financial security if they don’t consider the impact of upcoming expenses on their cash flow. Your balance sheet is a great tool to help you proactively monitor and evaluate your cash flow.
In addition to having a well-developed financial plan in place (that includes a balance sheet, cash a flow statement and an income statement) there are two easily calculated ratios that can be computed from the balance sheet to help determine whether your company will have sufficient cash flow to meet current financial obligations:
A widely used measure of short-term debt-paying ability. This is a liquidity measurement that indicates whether your company has enough current (i.e., liquid) assets on hand to pay bills on-time and run operations effectively. It is expressed as the number of times current assets exceed current liabilities.
The higher the current ratio, the better. A current ratio of 2:1 is generally considered acceptable for businesses that carry inventory, although industry standards can vary widely. The acceptable current ratio for a retail business, for example, is different from that of a manufacturer. The ratio is computed by dividing total current assets by total current liabilities.
The formula: Current Assets / Current Liabilities
Inventory and prepaid expenses are the least liquid of the current assets. In some businesses, it may take several months to convert inventory into cash. The quick ratio compares only the most liquid current assets—called quick assets—with current liabilities.
Quick assets include cash, marketable securities, and receivables—these are the current assets that can be converted most quickly into cash. This ratio is similar to the current ratio but only includes the quick assets (cash, marketable securities and receivables). A quick ratio of 1.5:1 is generally desirable for businesses that don’t carry inventory, but—just as with current ratios—acceptable quick ratios differ from industry to industry. The ratio is computed by dividing total quick assets by total current liabilities.
The formula: Quick Assets / Current Liabilities
Knowing your industry’s standards is an important part of evaluating your business’s balance sheet effectively. Comparing the average current ratio and quick ratio that are desirable for your business type, will give you a better sense of how your own business’s ratios stack up.
Get familiar with your balance sheet
Most companies should update their balance at least once per quarter, or whenever lenders ask for an updated balance sheet. Today’s accounting software programs will create your balance sheet for you, but it’s up to you to enter accurate information into the program to generate useful data to work from.
The balance sheet can be an extremely useful financial tool for businesses that understand how to use it properly. If you’re not as familiar with your balance sheet as you’d like to be, now might be a good time to learn more about the workings of your balance sheet and how it can help improve financial management.
If you’d like help creating your comprehensive financial plan and understanding the related financial statements … we can help. We specialize in helping businesses create comprehensive financial plans, monitor their financial activity and understand their financial statements. So, if you don’t have the expertise or resources, click here to contact us!
For more on small business financial plans, check out Part 5 for an explanation of the cash flow statement.