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Understanding the Balance Sheet

The Balance Sheet seeks understanding. She’s a quiet character, but when things go badly, she will make itself heard. So listen intently without comment until the Balance Sheet has said what she needs to say.

I jest— you don’t need to be the Balance Sheet’s therapist.

But you better make sure your business produces one right along with the monthly Income Statement. If not, I won’t call you out, but I hope when you finish reading this, you’ll understand why you need to fix that problem.

First, some things to note about the Balance Sheet that makes it different from the Income Statement:

1
“As Of” a date, not a period

The Balance Sheet is “as of” a certain date — usually the end of a month or year — and it represents the entirety of the business up until that date. The Income Statement (a/k/a as a Profit & Loss Statement) is for a period, again, usually a month or a year. Unlike the Balance Sheet, the Income Statement ignores anything prior to the period.

2
Never Resets to Zero

You probably know that the accounts on an Income Statement reset to zero at the beginning of a new year. No so for the Balance Sheet. Those accounts are never “reset.” When the prior year is “closed out” in your accounting system (which includes many activities, but most importantly, the reset of the Income Statement to zero), the prior year’s net income is added to Retained Earnings. Retained Earnings is in the Equity portion of the Balance Sheet. 

3
The Accounting Equation

Area = πr²

Not really. It’s Assets = Liabilities + Owner’s Equity.

No proofs, no theorems. It’s just the way it is.

4
It’s An Asset & Liabilities Listing

I really like one explanation I found that said the Balance Sheet is showing you all the assets of the company, plus it tells you how much of the assets were purchased with loans (liabilities) and how much were purchased with cash generated or put into the business (equity).

The Balance Sheet

Below is a sample Balance Sheet you can use a reference as I tell you about the three main sections: Assets, Liabilities, & Equity.

Assets

Let’s start with the Asset portion of the Balance Sheet. First, understand that the assets are listed in order of liquidity. Liquidity refers to the asset’s ability to be converted to cash. That’s why you’ll always find Cash at the top of a Balance Sheet. As you move down the Assets, the slowest to convert to cash will be at the end.

After Cash, you will find Current Assets. These are assets that should “turn” or will be converted to cash within a year.

Current Assets would include Inventory and Accounts Receivable. Inventory are goods held for sale. Accounts Receivable (A/R) is the dollar amount owed to you by others.

The Balance Sheet shows the value of the A/R, but it doesn’t help you evaluate the quality or age of the Receivables. Wouldn’t you feel better about receivables that belonged to 20 different customers that were 30 days old versus receivables made up of two customers that were 90 days old?

As you move down the Asset list, the value of items on the Balance Sheet become less reliable. If you list a building in your Fixed Assets that you bought 10 years ago, it will always stay on the Balance Sheet for what you paid for it (called Historical Cost). Plus, you will depreciate the building over many years (around 39).

But, is the building really decreasing in value? Probably not. So the Balance Sheet doesn’t tell you anything about its market value — it just tells you what was paid. So some companies are sitting on tremendously valuable real estate, yet their Balance Sheet does not reflect that at all.

Another dirty little secret about the Balance Sheet is it usually doesn’t show assets developed in-house and not purchased. For instance, if the company developed a software package, the costs were probably expensed as it was developed. So the company’s most valuable asset doesn’t even show up on their Balance Sheet. Strange, huh?

Liabilities

The next part of the Balance Sheet is the Liabilities section. This is a list of what you owe others. The first item will be the most liquid, usually Accounts Payable (the dollar amount of what you owe others) or A/P. Current Liabilities include any items that are due in less than one year. 

Customer Deposits or Unearned Revenue are considered a liability. Why? The company has taken money from a customer for which they have not yet delivered the product or service. (This also means that the amount will be recognized as revenue in the future.)

Note that for long-term debts, the amount due within the next year will be segregated into Current Liabilities.

Unlike the Asset section, which usually has some valuation issues, the liability section is pretty straight forward. The amount owed to another individual or entity is easy to value and document.

So let’s look at what happens if a company borrows money against an appreciated piece of property.

  • The loan would increase their long-term liabilities. 
  • The loan value could be much more than the asset they used as collateral, say the Building or Land.
  • The Balance Sheet would show a new Asset — either Cash or what they purchased with the loan.
  • If they used the loan to buy a new piece of equipment, their Fixed Assets-Equipment would increase.
  • If they used the loan for cash, the Cash asset would increase. But what if the business used that cash over time to fund their losses? The Cash asset would decrease and so would Retained Earnings. Because Assets = Liabilities + Equity, remember? That would also be a pretty ugly Balance Sheet with a big Liability and no offsetting Asset.

Equity

This term gets thrown out so much for so many different things, no wonder people get confused. For purposes of the Balance Sheet, just remember it’s the last part of the Balance Sheet, and it’s what money the owner(s) put in and what income (or loss) the company has generated over its lifetime.

It can also be called Owner’s Equity, Stockholders’ Equity, or Partners’ Equity, depending on the type of entity. They all mean the same thing.

On the Balance Sheet of an LLC or Partnership, you won’t see Common Stock, but you’ll see Member (or Partner) Contributions, which is also money put into the company by the owner. Member (or Partner) Distributions are just the opposite: money distributed to the owners.

Retained Earnings is merely the total of all net income (or loss) over the life of the company. Does it tell you anything? Kind of, sort of. It does tell you the difference between the company’s assets and liabilities. It does not give you the value of the company. One might argue that it really is just a plug figure that makes the Balance Sheet work. So don’t get hung up on it.

If you followed Accounting theory to the letter of the law, there would be no Current Earnings — it would already be included in Retained Earnings. However, in many accounting systems, Current Earnings is the earnings for the current year that has not yet been “closed out” to Retained Earnings. So technically, you should add Current Earnings and Retained Earnings to get the total company’s Retained Earnings.

Why Should You Care About Another Company’s Balance Sheet?

To answer the question, because it helps you understand their financial position. If you had to pick the most important part of the report, look at Cash and Debts. Always assume Inventory is overstated (and includes some old, non-sellable stuff) and that A/R probably has some uncollectible debts in it.

A/P & Liabilities are usually in pretty good shape because companies tend not to overstate what they owe others. So, though the Balance Sheet has its flaws and could be full of misstatements, it is a good starting point to evaluate the business’s worth.

Why Should You Care About Your Company’s Balance Sheet?

Okay, you argue that you don’t need to look at your Balance Sheet. You know what your debts are. You know what your A/R balance is. Well, I’m going to argue that you don’t know what has been buried on the Balance Sheet unless you see it each month.

I’ve worked with many a company where I found significant accounting errors that had been coded to Balance Sheet accounts instead of to the proper Income Statement accounts. The result is unrecognized income or expenses that swing the Income Statement significantly. And usually not in the way you want. (Seriously, I once cleaned up a company’s financial statements and determined that Cost of Goods Sold was understated by 50 percent— almost $700,000! The other half had been coded as an ASSET to the Balance Sheet.)

The Balance Sheet is also a key part of explaining your company’s cash flow. Your Income Statement can show tremendous income, but you don’t know why you don’t have any cash in the bank. Is the cash being used to pay down debt? Is it not yet cash because it is sitting in Accounts Receivable? Does Inventory keep increasing? The Balance Sheet can help you answer these questions.

And finally, most outsiders who request Financial Statements will expect a Balance Sheet, not just an Income Statement. If you ever want a bank loan, want to enter into a strategic partnership with another company, or you are raising equity from investors, you better have a Balance Sheet. And a strong one really helps.

If you want help cleaning up your Balance Sheet or just being told how great you are doing, give us a call. We do both.

head_shot Caroline Devoy founded Biz Hippo to provide outsourced accounting services to small- and medium-sized founder-run businesses. She has over 30 years of accounting experience in small businesses and for 10 years ran her own internet retail company. She writes on topics of interest to small business owners.

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