Most business owners tend to worry more about their Cash Flow, and Profit and Loss statement, than their Balance Sheet. The Balance Sheet tends to be an abstract notion that applies when their tax preparer asks about it. So why is it important to understand your Balance Sheet?
The Balance Sheet represents a snapshot of the business’s financial position. It shows the account balances in the bank, the assets, the liabilities, and the equity that make up the business worth. Or in layman’s terms: what the business owns and owes. The bank accounts and other assets are what the business owns and the liabilities are payments the business needs to make, in other words what it owes. Ideally, your equity in the business is positive, and so the assets should be equal to the liabilities and equity combined. Let’s break it down.
There are two types of assets: current and other (sometimes called non-current). Current assets are accounts that the business acquires, converts to cash in some method, and uses over the course of one year. Examples of these would be: bank accounts, customer outstanding invoices, short-term promissory notes or loans (owed to the business by a third-party), and inventory. Other assets are going to be your fixed asset items or investments over one-year. Examples of these would be: office equipment, property, investment accounts, and long-term promissory notes.
Here again, there are two types of liabilities: current and long term (sometimes called non-current). Current liabilities are items that must be paid within the year. Examples of these are: payroll taxes, garnishments, certain leases and/or payment option plans, short term loans (made by the company), vendor invoices. These are often listed as payables. Long term liabilities are those that fall due over one year from the date. Examples of these are: credit cards, lines of credit, bank loans, and equipment leases.
Equity is the most confusing section of the Balance Sheet. The easy way to think about equity is if you converted all of your assets to cash, and then paid off all of the liabilities, the remaining funds would be your equity. This is what the owner(s) is/are left with. This includes all paid-in-capital by the owner(s), yearly contributions and distributions, and any Retained Earnings maintained. Retained Earnings is the amount of money the business did not use to pay expenses, liabilities, or pay out to owner(s).
So why is this important, again?
If your liabilities and equity put you in a negative cash position – meaning your assets can’t fully pay back what you owe and there’s no money left in the company - the business is in trouble. Many business owners don’t pay attention to the Balance Sheet during the regular course of business. They are then caught flat-footed when something goes wrong. If your asset to liability ratio is less than 1:1, the business is in danger of going bankrupt if any snag is hit – a customer pays late, or not at all, you lose your workers, your materials provider needs to wait on a shipment, etc.
Banks will not often loan to a business that is a negative position, and so a source of funds for a bail out is often not available when it is most needed. You can at times find someone willing to loan, but the stakes will be higher – your interest rate and terms will not be in your favor.
Keeping an eye on your balance sheet at least on a quarterly basis will help you plan for the future by understanding where your business is headed and how it looks to outside parties