The Balance Sheet, in my opinion, is one of the most underestimated or ignored of all the financial statements. Most business owners focus on the Income Statement and ignore the Balance Sheet. This is a mistake. Sure it is important to know if you are making money or if you are losing money but it is also important to know if you have equity in your business.
What is equity? A simple way to understand equity is to think of it on a personal level. If you own a house that has a mortgage with a balance of $100,000 and has a Fair Market Value (potential sales price) of $150,000 then you have $50,000 in equity. In this case, a bank may allow you to refinance at a lower interest rate or let you get a home equity loan because you have equity.
The Balance Sheet will show an investor, banker or business owner how much equity a business has.
The Balance Sheet Formula is Assets = Liabilities + Shareholder Equity
Let’s break down the Balance Sheet in more detail.
The Balance Sheet is kind of like a company’s net worth statement. It reflects how much the company has in assets (cash, property), liabilities (how much the company owes its vendors, banks and bondholders), and shareholder equity (assets less liabilities = company’s net worth) at a specific point in time. For example, December 31st.
The Balance Sheet uses the accrual method of accounting. This means that revenue and expenses are recorded when the transaction occurs, regardless of when the payment is made.
There are three main categories of the balance sheet:
Assets:
Assets are any item of property owned by the company that has value. Assets are ordered from top to bottom, in order of liquidity, which means how quickly something can turn into cash. These categories are:
- Current Assets are expected to be sold, used or exhausted through standard business operations within one year. This includes assets like cash, accounts receivable and inventory.
- Long-term Assets are expected to benefit the company longer than a year. Long-term assets include tangible assets (physical-you can touch it) such as real estate, factories and equipment. Long-term assets could also include intangible assets (things that can’t be touched), such as goodwill, copyrights and patents.
Liabilities:
Liabilities reflect a company’s financial obligations owed to others. Liabilities are also ordered on the Balance Sheet from top to bottom, depending on how soon the company expects to pay them.
- Current Liabilities are bills due within the next year. This could be wages owed to employees, money owed to suppliers and taxes owed to the government.
- Long-term Liabilities are debts not expected to be paid off in the next year. This could include a pension liability, long term debt such as a mortgage or other loan.
Shareholder Equity:
Shareholder Equity (or Equity if not a corporation with shareholders) is the basically the net worth of a company on paper. This is the dollar amount that would be returned to shareholders (or company’s owner or partners – depending on the type of business you own) if all of the company’s assets were liquidated and its debts settled. This is also referred to as a company’s book value.
The Shareholder Equity section of the Balance Sheet includes retained earning (the cumulative profits that a business has kept since its inception), additional paid-in capital (the money that shareholders have invested – if a corporation) and treasury stock (the value of shares that a company has repurchased).
It is important to remember that a Balance Sheet may look slightly different depending on the type of organization (non-profit, for profit, C-Corp, Sole Proprietor, Partnership). The main difference will be reflected in the Equity section of the Balance Sheet.
As a business owner, especially a small business owner or start-up the focus on the Balance Sheet is ensuring that you have more assets than debt, especially if you are looking to get a bank loan. Bankers will insist on having a Balance Sheet as well as a current Income Statement. Many times, they will ask for the current statements and the last two years. Knowing and understanding your Balance Sheet will give you an understanding of what a banker is looking for. Here are some things that an investor or banker are looking for:
Are cash & cash equivalents less than total debt (do you have enough to pay off debt)?
Is Accounts Receivable rising faster than revenue (are your customers paying timely)?
Is Inventory rising faster than profits (are you struggling to sell the items on your shelves)?
Retained earnings is a negative number (meaning that you have a cumulative loss in your business)?
These are the questions that will be raised. If you know ahead of time what your numbers mean and you have an explanation for these areas you will be able to have productive conversations with the lender.
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