Introduction
Many of our small business clients who are looking to get into business, lack the fundamentals in accounting to know how to judge the health of their business. In this first episode of a new series, I will show you the basics of accounting including financial sheets and how to use them. In this video, we are covering our first financial statement, the Balance Sheet. I’ll show what a balance sheet is, the components, and stay to the end on how you can use it for your business.
What is a Balance Sheet
So let's get right to it. What is a balance sheet? A balance sheet is a financial statement that is a snapshot of your business's health. The balance sheet shows your business’s net worth and it is broken down into 3 sections: Assets, Liabilities, and Equity. These 3 sections will always be in balance when looking at this document. This formula is often associated with the balance sheet:
Assets - Liabilities = Equity
Typically, you will see balance sheets annually at the end of the accounting year (calendar or fiscal) to show how the business did. These sheets are inherently historical so they aren’t as helpful as other statements, but they still have a wealth of information for your business.
Components
As I mentioned before the balance sheet consists of 3 sections: Assets, Liabilities, and Equity. Let’s dive into each component a little more.
Assets
Our first section is Assets. Basically, an asset is something your business owns that can be converted into cash, for example, if something was sold. Some examples of assets are cash in the form of revenue like when you sell a product.
The inventory you have that you can sell to customers. Accounts receivable, which is money you are owed for selling a product or service you have yet to collect on.
These are all considered current assets or assets you can quickly convert to cash. Long-term assets like land, buildings, furniture, fixtures, and equipment take more time and effort but are still worth something.
Liabilities
Liabilities are the other side of this coin, this is what you owe to others. Like assets, Liabilities can be current and need to be paid within a year or long-term, which are owed longer that year.
Current liabilities can be monthly expenses like taxes or accounts payable. This could also include interest or payment on larger debts like a mortgage or business loan. Long-term liabilities could include the total amount of an SBA loan or pensions for long-term employees that are paid when they retire.
Equity
Our final section is equity. This is sometimes called shareholders equity if you have shareholders like in a corporation or simply owner’s equity if you are a sole proprietor. Equity is the total amount of money generated by the business or put into the business by its owner or shareholders. Think about it this way: Equity is net assets, illustrated by using this formula:
Equity = Assets - Liabilities
How to Use it
The balance sheet is a historical snapshot of how your business is doing at a single point in time. However, there are some more helpful things you can use on the balance sheet that doesn't require a finance degree. Financial ratios are simple formulas you can use to analyze or identify problems that may not be obvious by simply looking a the document.
The first of these ratios is the current ratio, which tells you if you have enough cash and short-term assets (current) to pay bills. The Current ratio is calculated using this formula
Current Ratio = Current Assets / Current Liabilities
A healthy current ratio is in the range of 1.5 to 2, but if it is higher than that, your business might be holding too much cash and you may want to invest.
If you are a product-based business you may want to use the quick ratio which is similar to the current ratio but it removes inventories for a more conservative estimation:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
The final way you can use the balance sheet is by calculating your debt to equity ratio. This simply gives you the ratio of what is owed to what is owned. Many lenders will use this formula to check if a business is carrying too much debt to lend to. Generally speaking, a D/E ratio less than 1.0 is “Good” and over 2.0 is bad, but you need to consider your industry averages like lenders do before you jump to any conclusions.
Conclusion
The balance sheet is a helpful tool to evaluate a company's net worth and solvency using the easy ratio formulas I showed you. As a business owner, you should be able to generate a balance sheet at least once a year, yourself or from your accountant to check on the health of your business. Ideally, you will want these statements quarterly or even monthly to get the most updated information to make informed decisions and manage your business.
Funded in part through a Cooperative Agreement with the U.S. Small Business Administration. All opinions, conclusions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA.
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